When you go to buy a home, you will learn that there are two kinds of mortgages: fixed-rate and adjustable-rate.
What’s the difference?
A fixed-rate mortgage gives you an interest rate that never changes. An adjustable-rate mortgage gives you a volatile interest rate: in times of slow economic growth and low inflation, the interest rate will be low; in times of high economic growth and inflation, the interest rate will rise.
Why do some people like adjustable-rate mortgages?
Advocates of adjustable-rate mortgages argue that these give you a shot at getting lower rates than you can ever get with a fixed-rate. In late 2010, when the average fixed-rate mortgage was 4.5 percent, I overheard a guy sitting at the table next to me at a sushi restaurant bragging to his dinner companions about his brand-new, adjustable-rate 3.25 percent mortgage.
It’s true that he’s getting a lower rate than those with fixed-rate mortgages … for now.
Are you willing to risk your home?
You can’t predict the future.
But what’s going to happen in 3 years, 5 years, even 10 years, when interest rates rise and this guy’s 3.25 percent rises to a whopping 6 percent or 7 percent?
Advocates for adjustable-rate mortgages argue two points:
1. You never know which type of mortgage will end up being cheaper in the end – why not keep open the possibility of a cheaper mortgage?
2. Paying 7 percent in 10 years … when you owes less on your mortgage … is better than paying 4.5 percent now, when you carry the heaviest loan on your mortgage. In other words, it’s better to owe a low interest rate on a big debt , and a high interest rate on a small debt.
No one lost their home because their monthly payment stayed the same.
To point #1: An adjustable-rate mortgage might be cheaper OR more expensive in the end — there’s no way to know. So why take on the added risk and uncertainty?
To point #2: Don’t assume that 5 years, 10 years, or 15 years down the road, when the rate on your mortgage rises, you’ll be in a position in which you’ll be able to handle the extra payments.
The future is uncertain ...
Let’s say you’re paying $700 a month on your mortgage right now. Four years down the road, you have a kid. Two years later you have another kid. The following year, your brother gets sick and you take one month off work, unpaid, to care of him. Then your furnace breaks down. Your car breaks down. A storm blows a heavy tree limb onto your roof, causing you to need a new roof. Gas prices have reached $5.50 a gallon. You discover you need eyeglasses. And – guess what? – now your interest rates have climbed, and your new mortgage bill is $1200 per month.
Can you afford it? More importantly — can you say, with absolute certainty, that you are SO SURE you’ll be able to afford any mortgage bill, no matter how high it climbs, at any time over the next 30 years, that you’re willing to take this incredible gamble …. knowing that if you lose this gamble, it will cost you your home?
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I prefer the cost certainty of a fixed rate mortgage too. What’s really a problem is that many people who stretched themselves to the limit just to afford the current interest rate will be in big trouble when interest rates start to rise.
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Interesting insights. I think one major point that is missing is that it matters a great deal what prevailing rates are at the time you buy your house. Certain prevailing rates may make adjustable rate mortgages more appealing. After all, rates will fluctuate every now and then at the end of each term with fixed rate too. On the other hand, I certainly appreciate the fact that you might not want to ‘bet the house on it’.
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I’m the opposite of you. I almost always take variable because there is a premium for the fixed rate. I always do the math, and it usually is worth more to take a variable interest rate for three reasons: 1) the lower rate saves lots of interest when the interest portion is high at the beginning of the loan and 2) if it goes up later it has to go way past today’s fixed rate to lose money and 3) years down the road the potential expensive rate will be paid with inflated dollars while the early savings will be paid with present day dollars.
If I can afford the risk I always go variable.
On other thing: I’m from Canada and mortgages here have a term far lower than the amortization period. So if I get a 20 year mortgage, the term or the contract will be 5 years or less after which time I renew or pay it off or switch banks, etc. In the US you probably contract for the life of the mortgage.
I would always go for a fixed rate mortgage, particularly as i don’t really keep up to date on changing trends and also it is easier to plan if you have a set amount to budget for each month, as opposed to an unknown amount. Whether it works out financially best at the end, well, i’ve no way of guessing that!
Adjustable rate mortgages are especially beneficial if you are planning to move in a few years and aren’t concerned about possible interest rates changes (which could happen very well). Moreover, ARMs initially come with lower interest rates than fixed deals, so this should also be taken into consideration when choosing a mortgage loan.
@Michael — But what if you don’t move in a few years? Or what if you can’t sell the house, and you’re stuck holding onto the house even after you move away, acting as an “accidental landlord” — as many people did after the housing crash of 2008?
If the interest rates skyrocket, you might lose the house. Why not have the peace of mind of knowing exactly what the payment will be? The marginally higher interest rate in the beginning is a cheap insurance.
Fixed rate loans are definitely the way to go because your payments will remain the same over the entire them. With adjustable rate mortgages there could be any kind of fluctuations (following the initial few years, when it comes with lower interest rates) that may result in higher mortgage payments.
ARM deals are especially beneficial in a decreasaing interest rate environment.