Buying a home is likely to be the largest purchase you will make during your lifetime. It’s important that you understand the terms of your loan and work with your lender to identify the best loan product for your situation. When looking at loan options, understand the advantages and disadvantages of a fixed-rate mortgage and how it compares to an adjustable-rate mortgage. As the name implies, with a fixed-rate mortgage, you lock in a fixed interest rate for the entire term of the mortgage. By comparison, the interest rate for an adjustable-rate mortgage can vary over the life of the loan.
Fixed-rate mortgages are available under a variety of terms, but regardless of the term of your loan, your interest rate will also be impacted by a range of other factors. Considerations include your credit score, how much money you’re borrowing, the value of your home, where your home is located and the size of your down payment.
Fixed-rate mortgage pros and cons
Fixed-rate mortgages are most commonly available with 30-year mortgages and 15-year mortgages. With a 15-year, fixed-rate mortgage you’ll usually get a lower interest rate and pay much less interest over the life of your loan, but you’ll have a significantly higher monthly payment than with a 30-year mortgage. Although a 30-year mortgage might be a better option if lower payments are a better fit for your budget, you’ll be building equity in your home at half the rate you would with a 15-year term.
So you can better decide if a fixed-rate mortgage is the right home loan for you, understand the details of the benefits and drawbacks of it beyond the loan terms.
Advantages of a fixed-rate mortgage
A fixed-rate mortgage can be a good option if you need to a home loan. Here are a couple reasons why it can be beneficial:
■ Protection against interest rate increases
The biggest advantage of a fixed-rate mortgage loan is that the interest rate is locked in for the term of the loan. If interest rates rise — or even double or triple — you still reap the benefits of the low-interest rate that you locked in at the start of your loan. Although adjustable-rate mortgages typically have several caps that determine how much your interest rate can rise, for many borrowers, a rate hike of a few percentage points can be burdensome.
A fixed-interest rate and stable monthly payment also allow you to budget for your monthly mortgage payment and not lose sleep worrying that rising interest rates will force you to cut back in other areas or even put your payment out of reach in the future. For example, if you used an adjustable-rate mortgage, and interest rates went up sharply, you could be paying hundreds more on your monthly mortgage payment.
■ Easier to compare loan options
If you like simplicity when it comes to shopping for your mortgage, it’s easier to compare fixed-rate mortgages because there are few moving parts: You just need to compare rates and closing costs. With an adjustable-rate mortgage, you must compare not only closing costs, but also the introductory interest rate, the length of the introductory period, how much the rate can change each adjustment, and how much the rate can change over the term of the mortgage. You could also consider a graduated payment mortgage, with lower payments to start, but which gradually increase over time.
Disadvantages of a fixed-rate mortgage
Before you commit to a fixed-rate mortgage, learn the drawbacks to this type of home loan so you don’t face any unexpected surprises. Here are two key disadvantages to a fixed-rate mortgage:
■ No benefit if interest rates fall
The downside to fixed-rate mortgages is that if interest rates fall, your mortgage rate won’t automatically fall along with it. Instead, if you want to take advantage of the lower rates, you must refinance — and pay the closing costs that come along with refinancing. Typical closing costs range between 2 percent and 5 percent of the loan amount, so refinancing can be costly.
If you had opted for an adjustable-rate mortgage, the interest on your loan would have typically fallen with the drop in rates. But just as there are caps on how high an adjustable rate can climb, most will also have a cap on how low your rate can fall.
■ No lower introductory rate
Fixed-rate mortgages don’t offer a lower introductory rate for the first few years of the mortgage like adjustable-rate mortgages do. As a result, a fixed-rate mortgage might cost more in interest over the first few years of your mortgage. In the long run, however, the stability of the fixed-rate mortgage might more than outweigh this temporary benefit, especially if you plan to remain in your home for a long time.
On the other hand, if you don’t plan to stay in your home for a long time, the introductory period of an ARM might be enough stability for you. The introductory rates are typically for five, seven or 10 years. For example, you might plan to stay in your home between four and six years. If you take out a 5/1 ARM, your introductory rate lasts for five years and you might end up selling your home before you see your payment go up. You could also take out a 7/1 ARM to fix your rate for seven years, ensuring you will not see an increase in your payment if you planned to sell sooner than that. However, you can expect to pay a slightly higher rate than with a 5/1 ARM.
When comparing an ARM versus fixed-rate mortgage, if you like stable monthly payments and the security of knowing how much interest you’re going to pay over the term of your mortgage, a fixed-rate mortgage could be for you. FRMs are also beneficial if you expect to be in the house longer than the lower, fixed introductory rate would last.
But if you’re only going to be in the home for a few years, you could save money with an ARM because of the lower introductory rate. Also, if you expect interest rates to fall, an ARM will allow you to take advantage of the lower rates in the future without having to pay the costs of refinancing.
Regardless of whether you believe a fixed-rate or adjustable-rate mortgage will best meet your needs, understand all the details of the loan products you are considering. Often, what’s in the fine print will determine what’s best for your home financing situation.