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Mortgages have been around since before the Great Depression, but they sure have changed since then.
Previously only available through private banks and with fairly undesirable terms, mortgages changed for the better for lenders and consumers, especially in 1934 when the Federal Housing Administration was created.
The new administration introduced the universal 30-year loan term, or length, which is the backbone of today’s most popular type of mortgage.
Hitting their height of popularity in 2004 when the Federal Reserve began raising the federal funds rate, adjustable-rate mortgages (ARMs) haven’t been around for quite so long. Introduced in the late 1970s, ARMs have endured a wild ride with the U.S. housing market.
Reminiscent of the subprime mortgages many borrowers defaulted on during the 2008 financial crisis due to predatory lending practices, ARMs haven’t had the best reputation for a while.
With interest rates at record lows in 2021, ARM loans are nearly obsolete. But rates can’t stay low forever, and with more government regulation and legislation, these mortgages are safer and still beneficial to some borrowers now.
Depending on the type of borrower and their goals, either a fixed-rate or adjustable-rate mortgage will make more sense for them. Both have advantages and disadvantages in today’s world.
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Fixed-Rate vs. Adjustable-Rate Mortgages: Overview
What’s the difference between the two? Just think about the words. Fixed vs. adjustable. It’s all about how interest works.
A fixed-rate mortgage keeps its interest rate constant through the life of the loan, and an adjustable-rate mortgage does not.
An ARM is like its counterpart during the first few years of its life, but then its interest rate is subject to change depending on the underlying benchmark rate it is tied to. Both types of loans come in 10-, 15-, 20- and 30-year terms.
Understanding Fixed-Rate Mortgages
With their simple conditions and predictability, fixed-rate mortgages are the most commonly used type by far. In fact, nearly 80% of all homebuyers nationwide opt into a 30-year fixed-rate mortgage when buying their home.
Though the homeowner’s interest rate is fixed, they can refinance at a later date if rates dip as long as they qualify.
Fixed-rate mortgages are also fully amortized, which means they have a set schedule for when the loan will be paid off through regular installments of interest and principal.
An amortized loan helps consumers understand their current and future costs.
Understanding Adjustable-Rate Mortgages
Adjustable-rate mortgages allow potential homeowners to lock in a low-interest rate for a specified period of time, usually 3, 5, 7, or 10 years.
However, after the introductory period ends, the rate will change, and lenders are banking it’ll go up. Just how much it changes depends on the benchmark rate the loan is tied to, usually a major index like the Secured Overnight Finance Rate (SOFR) or a U.S. Treasury rate.
An ARM loan contract will outline the customer’s margin or the markup in percentage points from the underlying index.
The margin dictates the spread of the borrower’s new interest rates over time. ARM loans also have limits on how much they can fluctuate, called caps, and they are partially indicated in the loan’s title.
For example, a 5/1 hybrid ARM, which is quite common, means the introductory phase is five years long, and the rate can then be adjusted once a year afterward. Other hybrid ARM terms are 3/1, 7/1, and 10/1.
Additionally, there are interest-only and payment-option ARMs, as if there weren’t enough choices already.
How Are ARM and Fixed-Rate Mortgages Similar?
During the beginning years of ARMs and fixed-rate loans, the two are nearly identical. Even the variances in interest rates are still not huge, especially in 2021.
The preapproval process is the same, and both require a minimum FICO credit score of 620, though it can vary slightly between lenders.
Both types of mortgages can be insured through the Federal Housing Administration, the Department of Veteran Affairs, and the United States Department of Agriculture.
How Are ARM and Fixed-Rate Mortgages Different?
Besides the obvious differences in how long a borrower’s interest rate remains constant, there are other contrasts between fixed-rate loans and ARMs.
Traditionally, fixed-rate mortgages have slightly higher rates than ARMs, and their contract conditions are much simpler.
ARM loans are best for buyers with specific short-term financial goals in mind, and fixed-rate loans are best for long-term homeowners.
When Should You Consider an Adjustable-Rate Mortgage?
Potential homeowners should consider ARMs under a few circumstances. First, if they are certain they will sell their new home before their rate gets adjusted.
No forever homes are recommended here. Second, if he or she is confident their income will significantly increase in the future, like a medical student studying to become a surgeon.
Finally, ARMs are useful when their rates are lower than that of fixed-rate loans.
When Should You Consider a Fixed-Rate Mortgage?
As the more traditional option, fixed-rate mortgages benefit families staying in their home long term.
They provide stability and help make budgeting a lot easier since monthly payments will only vary slightly due to property taxes or insurance premiums changes.
A fixed-rate loan also enables consumers to purchase more house for their money since monthly payments are so low, giving their family room to grow. A larger home does equal more upkeep and higher property taxes, though.
Is an ARM or a Fixed-Rate Mortgage Better?
There is no one-size-fits-all approach to securing a home loan. It’s like comparing a granny smith to a red delicious. Both are apples. Both appeal to different types of people. Doesn’t mean one is necessarily better or worse than the other.
Given the complexity of ARMs, potential homeowners must make sure they truly understand their loan terms to not get caught off guard in the future if payments drastically change.
Luckily, there is almost always the option to refinance if someone’s financial situation changes or they want to take advantage of a lower interest rate, which is happening in droves right now.
If rates were increasing instead, a fixed-rate mortgage would be protecting those same borrowers from refinancing.
ARMs vs. Fixed-Rate Mortgages Interest Rates
The major appeal of ARMs in comparison to their fixed counterparts is the potential to secure a low rate.
Though they start lower than fixed interest rates, ARMs rate will likely reset higher a few times over the loan’s life, thus increasing the mortgage payment.
Although rates are always changing, both types have recently dipped lower than they have in years.
The Federal Reserve has lowered rates in response to the coronavirus pandemic. At the time of this writing, an average 30-year fixed mortgage rate is about 3.00 percent. However, some lenders are advertising as low as 2.50 percent.
A 15-year fixed mortgage rate comes in at about 2.00 percent. At the end of the third quarter, the 5/1 ARM’s average rate is also about 2.00 percent.
Bottom Line: ARM vs. Fixed-Rate Mortgages
How advantageous one loan is over the other is tied to prevailing interest rates in the country and the goals of potential homeowners.
Individuals’ credit scores, debt-to-income ratio, loan-to-value ratio, and down payment all play a part in getting a mortgage.
It pays to shop around extensively for the best rates because getting into the best fit loan can save or cost people thousands of dollars.