How Fixed-Rate Mortgages Work and Compare to ARMs


BY The Lenders Network

fixed rate mortgages

The most common type of home loan is a fixed-rate mortgage, usually a 30 year term.

What is a fixed-rate mortgage?

With a fixed-rate mortgage loan you lock in your interest rate for the life of the loan. You never have to worry about your rate or payment changing, it remains the same until the end of the loan.

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Pros and Cons of Fixed-Rate Mortgages

Pros

  • Interest rate will never increase
  • Mortgage payment never changes
  • Many different term lengths to choose from

Cons

  • Higher interest rate than adjustable-rate mortgage
  • Higher monthly payment than with an ARM
  • Rate will never decrease even if mortgage rates fall

Adjustable-Rate Mortgage

An adjustable-rate mortgage, or ARM, as it is commonly referred to, is a loan term that start with a low introductory rate for a fixed period of time, that adjusts afterwards.

The most common type of adjustable-rate mortgage is a 5/1 ARM.

The first number represents the number of years the initial rate is locked in for, in this case 5 years. The second number is the number of years the rate can adjust thereafter.

A 5/1 ARM has a low teaser rate locked in for the first 5 years that adjusts annually afterwards.

Pros and Cons of Adjustable-Rate Mortgages

Pros

  • Lower rate than fixed-rate mortgage
  • Save a lot of money in interest
  • Lower monthly mortgage payment
  • Can afford to purchase a more expensive home

Cons

  • Interest rate may increase
  • Monthly payments will increase over time
  • May have to refinance once teaser rate expires

What is Better, Fixed-Rate or Adjustable-Rate Mortgage?

Both types of loan terms have their own advantages and disadvantages. Your own personal situation will determine if a fixed-rate or adjustable-rate mortgage is best for you.

If you plan on living in the home for more than 5 years then a fixed-rate mortgage is a better option. However, if you plan on selling the home within the first 5 years you can save a lot of money by getting an ARM.

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When a Fixed-Rate is Best

  • Interest rates are at all time lows
  • You plan on staying in the home for more than 5 years
  • You’re self-employed or your income is not consistent
  • You plan on paying off the home within 5 years

When an Adjustable-Rate is Best

  • You plan on selling the home within 5 years
  • You expect an increase in your income
  • Current rates are unusually high and expected to fall

Comparing a Fixed-Rate vs. an ARM

In order to really compare the two types of loan terms let’s look at an example.

Let’s say you need a mortgage for $250,000 to purchase a new home.

You have two options:

  • A 30-year fixed-rate mortgage with a 5% interest rate – Payment: $1,625
  • A 5/1 ARM with a 4% interest rate – Payment: $1,476

With the fixed-rate mortgage you will have a monthly mortgage payment of $1,625.

The 5/1 ARM monthly payment is $1,476. That’s $149 per month cheaper. A total of $8,940 cheaper over the first 5 years of the loan.

Types of Fixed-Rate Mortgages

There are a few lengths of fixed-rate terms you can choose from. The shorter the term the lower the rate will be.

10 year fixed rate – This term is the shortest available, it offers the lowest rate you can get with a fixed-rate but also has the highest monthly payment.

15 year fixed rate – The 15 year fixed rate mortgage is becoming more and more popular because it features a fixed-rate that is almost as low as an ARM, but is fixed for the life of the loan.

30 year fixed rate – The 30 yr fixed-rate mortgage loan is the most popular loan term used in the U.S. It features an average interest rate with reasonable monthly payments

40 year fixed rate – This is a new loan term that is offered by some lenders. It provides the lowest monthly mortgage payment, however, it will have the highest interest rate.

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