Fixed Rate Mortgage vs. Variable Rate (Adjustable) Mortgage

All mortgages fall into two basic categories.  A mortgage is either a fixed rate mortgage (FRM) or a variable rate mortgage, commonly known as an adjustable rate mortgage (ARM).

A fixed rate mortgage has an interest rate that does not change.  As you might know, interest rates, which are essentially the cost of borrowing money, do change quite frequently.  These changes are influenced by many, mostly unpredictable factors, and when they occur, these variations in the “cost of money” are passed on to the consumers of money, i.e. the borrowers.  Fixed rate mortgages do exactly what their name suggests.  They fix the interest rate so that it remains the same no matter what changes the market brings.  If current interest rates not too high, these loans are less risky to the borrower, who is shielded from interest hikes, but riskier to the lender, who might be in a position of collecting an under-valued rate when interest rates go up some time in the future.  When this disparity in risk between borrower and lender happens, the interest rate of a new fixed rate mortgage is higher than the initial rate of an equivalent adjustable rate mortgage, but the latter may go up in the future, while the former never does.

An adjustable rate mortgage is a mortgage whose interest rate changes throughout the loan’s term.  These changed depend upon various conditions in the financial markets.  In most types of ARM loans, when the interest rate changes so does the monthly payment, but some adjustable rate mortgages have fixed payments that stay so regardless of the interest rate.  This might sound good, but can lead to a situation called negative amortization in which the debt increases every month despite the payments made.  A very common type of adjustable rate mortgage is the hybrid loan, which combines features of the ARM and the FRM.  In a hybrid loan, the interest rate is fixed for the first few years, at the end of which the loan turns in to a regular ARM.

When Should You Get a Fixed Rate Mortgage?

• When interest rates are relatively low, especially as compared to the past 2-3 years.  Interest rates can vary greatly, and have ranged from about 19% to 5% in the last three decades.  If rates are low and it seems they will be going up in the future, then locking the low interest with a FRM is a good idea.  On the other hand, if interest rates are relatively high then a FRM might not be the best choice.
• When you’re planning on holding on to a property for the long term, typically more than five years.
• When you want the certainty of a fixed rate.  If you want to be able to budget your future housing payments precisely and be sure of a steadily increasing equity in your home, then the predictability of a fixed rate mortgage is for you.

When Should You Get an Adjustable Rate Mortgage?

• When interest rates are relatively high as compared to the last few years.  If it seems like rates are going to go down, then an ARM is a good choice, otherwise if rates are at historic lows, adjustable rate mortgages should be avoided.
• When you are planning on moving a lot and not hold on to a property for a long time.  If you’re planning on selling your home and settling the mortgage within a short period of time (less than about five years) then you’ll be doing so before interest rates will have much chance to vary.  In this case you’ll be taking advantage of the typically lower starting interest rate of an adjustable rate mortgages.
• If you’re not too risk averse, then you might consider taking an ARM when interest rates are in the middle of the historic range.  In this case you’ll benefit from the lower starting interest rate of and adjustable rate mortgages and still have a good chance of rates going lower still.