When buying a home, the first thing on your mind is likely to pay for the home. Unless you’re able to shell out cash for the transaction, you should start to think about applying for a mortgage. While there are many options for mortgages now, the most popular conventional mortgages are fixed or adjustable-rate mortgages. This blog will compare the two so that you can better understand your options.
Fixed-Rate Mortgages
A fixed-rate mortgage is a home loan with a constant interest rate for the entire duration of the loan. This simply means the interest rate remains unchanged from start to finish. These mortgages are popular among home-buyers who prefer predictable monthly payments. Fixed-rate mortgages can be open or closed, with common terms of 15 or 30 years, or a length agreed upon by the lender and borrower.
A fixed-rate mortgage maintains the same interest rate throughout the loan term. Once the interest rate is locked in, it does not fluctuate with market conditions. This makes fixed-rate mortgages appealing to borrowers seeking predictability and those who plan to hold onto their property for the long term. In the United States, fixed-rate mortgage terms typically range from 10 to 30 years, with 10, 15, 20, and 30 years being common increments. Among these, 30-year and 15-year terms are the most popular.
Adjustable-Rate Mortgage (ARM)
Adjustable-rate mortgages (ARMs) are a blend of fixed- and variable-rate loans, featuring both fixed and variable interest rate components. They are typically issued as amortized loans, meaning borrowers make steady installment payments over the loan’s life. Initially, ARMs require a fixed interest rate for the first few years, followed by a variable interest rate that adjusts periodically. Amortization for an ARM is somewhat more complex than for a fixed-rate mortgage due to the varying interest rates that apply during the loan’s life. Initially, ARMs feature a fixed interest rate for a specified period, typically from three to ten years. During this time borrowers have a stable monthly payment based on this fixed rate. The amortization schedule during this beginning phase is straightforward; borrowers pay down both the principal and interest consistently, allowing them to build equity in their homes.
The amortization schedules for ARMs are more complex than those for fixed-rate loans due to the variable-rate portion, leading to varying payment amounts over time. Unlike fixed-rate loans, which offer consistent monthly payments, ARMs’ payments can increase or decrease depending on interest rate changes.
ARMs appeal to borrowers who are comfortable with the unpredictability of fluctuating interest rates. They are also favored by those planning to refinance or sell the property before the adjustable period begins. These borrowers often anticipate that interest rates will fall in the future, which would decrease their payments over time.
The popularity of ARMs tends to fluctuate with the rise and fall of traditional mortgage rates. When 30-year fixed rates are low, ARMs see a dip in popularity. For example, CoreLogic data shows that only 6% of mortgage applications for 30-year loans were for an ARM in January 2021, when rates were at historic lows. ARMs’ popularity rose to 25% in November 2022, as the average fixed mortgage rate hit 6.8%.
Impact and Popularity
Adjustable-rate mortgages (ARMs) are often most popular when fixed-rate mortgage rates rise, as they often provide lower initial interest rates, making them appealing to homebuyers looking to save on monthly payments. The psychology behind this trend often stems from borrowers’ desire to capitalize on short-term savings and their belief that they will either refinance or sell their homes before the adjustable-rate period begins, which leads them to take on the perceived risk of fluctuating rates. Many homeowners who opted for ARMs in the past few years are now facing the consequences of this decision as they near the end of their fixed-rate periods; they are preparing for substantial increases in their monthly mortgage payments, coinciding with a time when interest rates have reached their highest levels in decades. This situation has prompted a wave of regret among borrowers, as they realize that the initial savings of an ARM can quickly evaporate under current market conditions. With many now recognizing the financial strain associated with the looming adjustments, homeowners are confronted with difficult choices: whether to refinance into a fixed-rate mortgage at elevated rates, which may result in higher long-term costs, or to remain in their ARMs and endure potential payment spikes that could impact their budgets and financial stability.
As rates rose in 2022, more homeowners opted for ARMs with shorter terms, such as 3-year ARMs. Many of these homeowners are now nearing the end of their introductory period and facing higher payments as their rates adjust. For instance, a homeowner who took out a 5/1 ARM in 2019 at a low introductory rate may now see significant payment increases as the rate adjusts based on current market conditions.
Conclusion
Most homeowners can’t afford to pay cash for their homes, necessitating mortgages. With various products available, it’s important to research and choose the one that best fits your needs. Fixed-rate mortgages offer the security of knowing your rate won’t change, while ARMs provide lower initial payments but come with the risk of higher rates later.
The decision between a fixed-rate mortgage and an ARM depends on your financial situation and tolerance for risk. Those who value predictability and stability may prefer fixed-rate mortgages, while those willing to bet on future rate declines might opt for an ARM. However, the current rate environment and economic conditions should always be considered when making this important decision.
