Decoding mortgage basics: Understanding fixed-rate vs. adjustable-rate mortgages

Buying a home is a major milestone that has a big impact on your long-term finances and usually involves securing a home loan.

The two most common types of mortgages available to buyers are a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM). The difference between a fixed-rate mortgage and an adjustable-rate mortgage is that with an FRM the interest rate remains the same over the life of the loan. The interest rate on an ARM is variable and may go up or down based on current market rates.

Both types of mortgages have their advantages and drawbacks. Understanding the features of each option is essential to making a smart decision that aligns with your financial goals and risk tolerance.

How fixed-rate mortgages work

A fixed-rate mortgage has an interest rate that remains the same throughout the loan’s term, usually 30 or 15 years. Payments remain the same from month to month. This predictability allows borrowers to effectively budget without worrying about fluctuations in their mortgage payments.

Keep in mind that mortgage payments are often bundled with property taxes and homeowners insurance premiums, which can change over time. The total amount of your monthly payment may still fluctuate slightly with an FRM, although the principal and interest portion of your mortgage payment remains constant.

How adjustable-rate mortgages work

An adjustable-rate mortgage has a set interest rate for a specified period of time, usually three, five, seven, or 10 years. Once the introductory interest period ends, your interest rate will change periodically based on a benchmark index.

How often your interest rate adjusts is typically indicated in the name of the loan. For example, a 5-Year ARM, or a 5/6 ARM means the interest rate will remain the same for the first five years of the loan, and then adjust every six months until the loan ends.

One advantage of ARMs is that the interest rate initially starts lower than fixed-rate loans. But keep in mind that, because ARMs will eventually adjust periodically based on market conditions, your monthly payments could fluctuate significantly from time to time. 

ARMs do have rate caps to limit how much your interest rate can rise or fall in a single period or over the life of the loan. For example, an ARM with a 2/1/5 rate cap structure means your loan may increase or decrease by 2% during the first adjustment period, and up to 1% with each adjustment thereafter. Your interest rate cannot fluctuate more than 5% above or below the initial rate over the course of the loan.

Read more: Housing affordability index

Pros of fixed-rate mortgages

Stability and predictability

The primary advantage of FRMs is their stability. Borrowers can plan their finances with confidence, knowing that their monthly mortgage payments won’t change over time.

Protection against interest rate increases

Fixed-rate mortgages shield borrowers from the impact of rising interest rates. Even if market rates soar, the interest rate on an FRM remains locked in, providing insulation against economic fluctuations.

Long-term financial planning

Fixed-rate mortgages are ideal for those who prefer a long-term financial plan with consistent payments. This is particularly beneficial for homeowners on a tight budget or fixed income.

Cons of fixed-rate mortgages

Higher initial interest rates

Fixed-rate mortgages often have higher initial interest rates compared to the initial rates of adjustable-rate mortgages. This can result in higher upfront costs for borrowers.

Less flexibility during low-interest periods

During economic downturns or low-interest rate markets, borrowers with fixed-rate mortgages may miss out on potential savings compared to those with adjustable-rate mortgages.

You can consider refinancing your mortgage with a lower interest rate during these periods, but refinancing is not always an option due to a wide range of variables and includes associated fees.

Pros of adjustable-rate mortgages

Lower initial interest rates

ARMs often have lower initial interest rates compared to fixed-rate mortgages. This can result in lower initial monthly payments and increased affordability, particularly for those who plan to stay in their homes for a relatively short period.

Potential for significant savings

If market rates remain stable or decline during the initial fixed-rate period, borrowers can benefit from significant savings compared to FRMs. After that initial period, if rates remain stable or decline, ARM holders could also see lower overall interest costs over the life of the loan.

Flexibility for short-term homeownership

ARMs can be advantageous for individuals who anticipate selling or refinancing their homes before the first interest rate adjustment. This is common for those planning to live in a home for a limited period.

Cons of adjustable-rate mortgages

Uncertainty and risk

The primary drawback of ARMs is the inherent uncertainty and potential for rising interest rates. Monthly payments can increase, sometimes significantly, causing financial strain for borrowers.

Limited budget predictability

Unlike FRMs, ARMs lack the predictability of fixed payments, making it challenging for borrowers to plan their long-term budgets.

Choosing the right mortgage

There’s no right or wrong answer when it comes to choosing between a fixed-rate versus an adjustable-rate mortgage. While the majority of homebuyers opt for a fixed-rate mortgage for their stability, consider your own personal and financial goals.

Consider a fixed-rate mortgage if

• You’re planning to stay 10 years or more. The predictability of a stable monthly payment is good for long-term planning.
• You have a tight monthly budget. If the fluctuations of an ARM could upend your household budget, an FRM is likely a better choice.
• You want to lock in a low rate: If you’re buying in a low-interest market cycle, locking in a low rate could save you thousands over the long term.

Consider an adjustable-rate mortgage if:

• You’ll be in the home for a limited time. Whether it’s your “starter home” and you plan to move before the introductory period ends, or you’re close to retirement and are refinancing before you sell and downsize, an ARM may allow you to save money while taking advantage of a lower interest rate.
• Your budget can handle the fluctuations. If both your risk tolerance and budget can handle uncertainty and possible increases, the initial lower rates of an ARM might be a good option for you.
• You’re buying in a high-interest cycle. In a market with rising interest rates, an ARM’s lower initial interest rates might make sense.

Whether your priority is the stability of fixed payments with an FRM, or the affordability of an ARM’s initial lower interest rates, the right mortgage is the one that aligns with your personal circumstances, needs, and financial goals.

Written by Billy Guteng. December 20, 2023

Billy is a content writer for Kukun. He was born in France, and has lived in multiple cities around the world ever since. He loves art, design and architecture as well as construction and real estate.