Fixed-Rate vs. Adjustable-Rate Mortgages

All mortgages can be classified as either a fixed-rate or an adjustable-rate mortgage. There are several loan packages in each, but understanding these broad classes will help set a foundation moving forward. So what's the difference between the two mortgages? Let's break it down.

fixed-rate mortgage: breakdown

Both mortgages are different in how their rates are set. The easiest - and most recommended - type to deal with is the fixed-rate mortgage (FRM). As it suggests, a FRM has the same interest rate throughout the ENTIRE life of the loan. This makes it very easy to plan and set a budget for as a FRM won't surprise you with sudden increases.

What buyers and homeowners need to understand though, is the way a fixed-rate mortgage monthly payment is distributed between the principal and interest through the life of the loan. Investopedia gives a great example - using a 30-year FRM, principal of $100,000 with 6% interest rate, and assuming a monthly payment of $599.55:

Here's a free Google sheet you can use to play around with numbers. Remember to make a personal copy first to enter values.

Within the fixed-rate mortgage class, the biggest difference between the loans is the period or terms as to how long you're willing to pay back the principal. The most common terms are 30, 20, and 15 years. Remember: Longer-period terms = lowest payment, but you end up paying more interest than shorter-term FRMs. In a shorter-term FRM, the lenders assume they'll be getting their money back (principal) sooner - so they allow for lower interest rates.

adjustable-rate mortgage: breakdown

Let's start this the same way - as the name suggests, an adjustable-rate mortgage (ARM) has interest that changes based on benchmark indexes. ARMs usually start off with a lower rate than the market, which changes over time depending on what your loan's rate is tied to. In our rate updates (thank you, Freddie Mac!), we present the weekly market changes in the 5/1-year ARM. If you agreed to a 30-year 5/1 ARM, your rate will be set for the first 5 years of the loan and adjusted every year for the remaining years.

Here are a few other things to know about how the adjustable-rate mortgage is handled:

• Benchmark indexes: The 3 different indexes that ARMs are typically based on are the Constant Maturity Treasury (CMT), 11th District Cost of Funds (COFI), and the London Interbank Offering Rate (Libor).
• Margin: This is a fixed rate that's added to your indexed rate (based on benchmark indexes, see above point). If your ARM is set with a margin of 3%, that's added on top of the rate that your mortgage is benchmarked from.
• Cap structure: There are 3 different types of caps, all meant to limit how much your rate increases - periodic rate cap (can change every year), lifetime rate cap (limits the increase for the life of loan), and payment cap (limits increase of monthly payment, instead of increasing rate).

so which rate type is best?

We're sorry, but it really depends. Everyone's personal situation is unique, but we can help walk you through the numbers and to prepare when you're ready. We've also provided a pros/cons table for you below. If you have any questions, just let us know!