You're about to become a homeowner—this is an exciting time! As you begin working with lenders on securing pre-approval for a mortgage, you probably hear some terms when it comes to mortgage interest rates such as "fixed" and "adjustable." To help you make a smart decision, here’s what you need to know about these types of interest rates.
Interest Rate 101
An interest rate is the cost of borrowing money. When you borrow money to purchase a home, the interest rate applies to how much the home will cost you with borrowed money rather than saving a lump sum for the entire purchase price.
Fixed Interest Rate
The most straightforward type of rate is a fixed one. With a fixed interest rate, this means the rate and payments stay the same, regardless of what's happening with the economy. Some homebuyers may be drawn to fixed interest rates since they offer rate security, making for easy budgeting. The most common is the 30 year fixed, but there are other options as well, like a 15 year fixed rate, which will require a larger monthly payment but less interest over the life of the loan, and can be paid off in half the time.
In the event rates go down, homeowners with fixed-rate mortgages always have the option to refinance. Refinancing with a reduced rate will save you some money, but keep in mind there will be upfront closing costs and time spent getting approved for a mortgage all over again with your tax documents, bank statements, and more.
Adjustable Interest Rate
Often referred to as an Adjustable Rate Mortgage, or "ARM," these types of loans can make sense for some buyers, though do come with some degree of risk depending on your circumstances. With an adjustable interest rate, borrowers are offered lower rates and subsequently lower monthly payments early in the mortgage loan term.
An adjustable rate is a less expensive way for homebuyers who don’t plan on staying in one place for very long, and often have an initial fixed rate period of 3, 5, 7, or even 10 years.
After that term, with an ARM, your rates and payments can go up or they can come down. These rates will usually have an annual cap, so if rates rise significantly and quickly, you will not feel the full affect right away.
The low initial cost of adjustable-rate mortgages might be tempting, but they bring a degree of risk and uncertainty in the long run.
Fixed or Adjustable Interest Rate: Which Is Better?
There isn’t a straightforward answer about which type of interest rate might be better than the other. There are several unique factors to take into account such as the length of your loan, the index your lender uses, the number and timing of rate adjustments, and any assumptions about the future increase or decrease in rates. And of course, how long you intend to own the property.
Work with a reputable and trustworthy lender to review the pros and cons of each type of interest rate for your situation. Have questions or just looking for a little advice on where to start? Get in touch!