The two forms of mortgages with varying interest rate structures are fixed-rate mortgages and adjustable-rate mortgages (ARMs). In contrast to adjustable-rate mortgages (ARMS), fixed-rate mortgages feature an interest rate that doesn’t alter throughout the course of the mortgage’s term. Find out more about the differences between fixed-rate and adjustable-rate mortgages, as well as their advantages and disadvantages.
A fixed-rate mortgage has an interest rate that remains unchanged throughout the loan’s term. So, your payments will remain the same each month. (However, the proportion of the principal and interest will change.) The fact that payments remain the same provides predictability, which makes budgeting easier.
The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed-rate mortgages are also easy to understand.
A potential downside to fixed-rate mortgages is that when interest rates are high, qualifying for a loan can be more difficult because the payments are typically higher than for a comparable ARM.
The partial amortization schedule below shows how you pay the same monthly payment with a fixed-rate mortgage, but the amount that goes toward your principal and interest payment can change. In this example, the mortgage term is 30 years, the principal is $100,000, and the interest rate is 6%.
A mortgage calculator can show you the impact of different rates and terms on your monthly payment. Even with a fixed interest rate, the total amount of interest you’ll pay also depends on the mortgage term. Traditional lenders offer fixed-rate mortgages for a variety of terms, the most common of which are 30, 20, and 15 years.
The 30-year mortgage, which offers the lowest monthly payment, is often a popular choice. However, the longer your mortgage term, the more you will pay in overall interest.
The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame. Shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. So, shorter term mortgages usually cost significantly less in interest.
An ARM may be a better option in several scenarios. First, if you intend to live in the home for only a short period of time, you may want to take advantage of the lower initial interest rates ARMs provide.
The initial period of an ARM where the interest rate remains the same typically ranges from one year to seven years. An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early before interest rates can rise.
An ARM may also make sense if you expect to make more income in the future. If an ARM adjusts to a higher interest rate, a higher income could help you afford the higher monthly payments. Keep in mind that if you cannot afford your payments, you risk losing your home to foreclosure.
The interest rate for an adjustable-rate mortgage is variable. The initial interest rate on an ARM is lower than the interest rate on a comparable fixed-rate loan. Then the rate can either increase or decrease, depending on broader interest rate trends. After many years, the interest rate on an ARM may surpass the rate for a comparable fixed-rate loan.
Read Also: Understanding Refinance
ARMs have a fixed period of time during which the initial interest rate remains constant. After that, the interest rate adjusts at specific regular intervals. The period after which the interest rate can change can vary significantly—from about one month to 10 years. Shorter adjustment periods generally carry lower initial interest rates.
ARMs are more complicated than fixed-rate loans, so understanding the pros and cons requires an understanding of some basic terminology. Here are some concepts you should know before deciding whether to get a fixed vs. adjustable-rate mortgage:
- Adjustment frequency: This refers to the amount of time between interest-rate adjustments (e.g. monthly, yearly, etc.).
- Adjustment indexes: Interest-rate adjustments are tied to a benchmark. Sometimes this is the interest rate on a type of asset, such as certificates of deposit or Treasury bills. It could also be a specific index, such as the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index or the London Interbank Offered Rate (LIBOR).
- Margin: When you sign your loan, you agree to pay a rate that is a certain percentage higher than the adjustment index. For example, your adjustable rate may be the rate of the 1-year T-bill plus 2%. That extra 2% is called the margin. Consumer Financial Protection Bureau.
- Caps: This refers to the limit on the amount the interest rate can increase each adjustment period. Some ARMs also offer caps on the total monthly payment. These loans, also known as negative amortization loans, keep payments low; however, these payments may cover only a portion of the interest due. Unpaid interest becomes part of the principal. After years of paying the mortgage, your principal owed may be greater than the amount you initially borrowed.
- Ceiling: This is the maximum amount that the adjustable interest rate can be during the loan’s term.
A major advantage of an ARM is that it generally has cheaper monthly payments compared to a fixed-rate mortgage, at least initially. Lower initial payments can help you more easily qualify for a loan.
A borrower who chooses an ARM could potentially save several hundred dollars a month for the initial term. Then, the interest rate may increase or decrease based on market rates. If interest rates decline, you will save more money. But if they rise, your costs will increase.
ARMs, however, have some downsides to consider. With an ARM, your monthly payment may change frequently over the life of the loan, and you cannot predict whether they will rise or decline, or by how much. This can make it more difficult to budget mortgage payments in a long-term financial plan.
And if you are on a tight budget, you could face financial struggles if interest rates rise. Some ARMs are structured so that interest rates can nearly double in just a few years. If you cannot afford your payments, you could lose your home to foreclosure.
Indeed, adjustable-rate mortgages went out of favor with many financial planners after the subprime mortgage meltdown of 2008, which ushered in an era of foreclosures and short sales. Borrowers faced sticker shock when their ARMs adjusted, and their payments skyrocketed. Since then, government regulations and legislation have increased the oversight of ARMs.
The biggest difference between a fixed-rate mortgage and an ARM is that your monthly payment won’t ever change with a fixed-rate loan. With an ARM, the payment changes after the introductory period is over. The other key differences include:
- Initial interest rate: An ARM typically has a lower initial interest rate — and by extension, a lower monthly payment — than a fixed-rate loan.
- The interest rate over time: After the ARM’s initial rate period, the rate and monthly payment can rise (or fall). If it increases, you could wind up with an unaffordable monthly payment after the first few years of your loan term. A fixed-rate mortgage, by contrast, has a fixed payment throughout the life of the loan; the rate and payment won’t change unless you refinance to a different loan.
- Rate caps: The rate on your ARM has a ceiling: It can’t increase past a certain point with each adjustment or over the life of the loan.
- Down payment minimum: A conventional ARM requires a slightly higher down payment of 5 percent, compared to 3 percent for a conventional fixed-rate loan.
While the initial payment of an ARM might look more attractive than a fixed-rate payment, it’s important to know the maximum amount you could wind up paying, too. In this example, we illustrate the potential for a worst-case scenario, assuming a first adjustment cap of 5 percent, a subsequent adjustment cap of 1 percent, and a lifetime cap of 5 percent:
|5/1 ARM (30 years)
|30-year fixed-rate mortgage
|$370,500 (5% down)
|$378,300 (3% down)
|Initial interest rate
|Initial mortgage payment
|Maximum interest rate
|Maximum mortgage payment
Note that the max interest rate above wouldn’t appear overnight. Lenders typically cap rate adjustments at 1 or 2 percentage points per period, and there’s no rule that it’ll go up, either: It’s all up to the market. You could wind up lucky and see the rate fall, too.
Fixed-rate mortgages and adjustable-rate mortgages aren’t entirely different animals. These two types of loans have some components in common:
- Both come with standard 30-year repayment options: Both conventional fixed-rate and adjustable-rate mortgages offer standard 30-year terms.
- Both require good credit to qualify: With either a fixed-rate mortgage or an ARM, a lender will be assuming a certain level of risk to loan you the money. With that in mind, you’ll need good to excellent credit to get approved and with the most favorable terms.
- Both can be refinanced: Whether you have a fixed-rate or an adjustable-rate mortgage, you’ll have the option to refinance down the line. (With an ARM, this is the key to getting out of the loan prior to the first rate reset, if that’s your plan.)
Can I Switch From Variable to Fixed?
Getting a variable-rate mortgage has the notable benefit of allowing you to convert it to a fixed-rate mortgage at any time during the term without incurring any fees. If variable rates increase and put your finances in the red, making this type of transfer can lead to more manageable monthly mortgage payments.
Like making any other mortgage decision, switching from a variable rate of interest to a fixed rate during your term calls for careful consideration to be sure you’re acting appropriately.
With a variable-rate mortgage, the interest rate varies in response to changes in the lender’s prime rate, which is in turn dependent on the overnight rate set by the Bank of Canada. Variable mortgage rates go along with prime rates as the overnight rate increases or decreases. No matter what happens to interest rates or the overall state of the economy, the interest rate on a fixed-rate mortgage is fixed for the entire period of the loan.
When the economy is stable, variable mortgage rates are typically lower than fixed rates. But if interest rates rise, you can wind up paying far more for your variable-rate mortgage than you budgeted for. In these cases, switching to a fixed mortgage rate can be a strategic hedge against even higher costs.
But timing a rate switch can be tricky. You shouldn’t necessarily switch to a fixed rate just because your variable rate has risen once or twice, especially if you’ve been stress tested and your finances can handle these moderate increases.
Switching to a fixed-rate mortgage makes the most sense if:
- Variable rates are expected to increase rapidly.
- Variable rates become higher than posted fixed rates.
- Variable rates could stay elevated for an extended period of time.
- Further rate increases will make it difficult for you to afford your mortgage payments or other necessities.
Note that most of these scenarios require insight into where mortgage rates could be heading. Speak with your lender or mortgage broker to get a professional’s take on future rate activity and how a rate switch might affect you.
Having a discussion about future mortgage rates should inform your initial ‘fixed versus variable’ decision. But remember that rate movements are hard to predict. Just ask anyone who took out a variable rate mortgage before the Bank of Canada raised its overnight rate eight times between March 2022 and January 2023 — and again on June 7.
Switching your mortgage’s rate type is relatively simple. It shouldn’t take more than a phone call to your lender or broker, who will then arrange the switch for you. Your new mortgage rate will depend on two factors: how much time you have left on your mortgage term and your lender’s current, posted fixed mortgage rates.
If you have a five-year term that has two years left on it, for example, your rate will be based on your lender’s two-year fixed mortgage rates. You’ll be charged the posted rate for that product, which will generally be higher than the special rates offered to entice borrowers.
Switching lenders to secure a lower rate, more favorable terms, or better service, however, is a much bigger deal. In that case, you’d have to break your mortgage contract, refinance and be charged a prepayment penalty.