Fixed vs. Adjustable-Rate Home Loans: Which Type of Mortgage is Right for You?

If you’re like many aspiring homeowners, you’re probably most excited to find a home you love in the neighborhood you want to live in. However, it pays off to spend time researching your mortgage options so you can figure out your best loan option.

From choosing between conventional and government-insured loan programs to deciding on the right loan term and type of interest rate, it’s easy to feel overwhelmed by the variety of mortgage options. And here you thought all you had to do was establish a good credit score and save for a down payment.

Sometimes all you need is a helping hand from an experienced professional. At Union Bank, our locally-based mortgage lenders have been helping Vermonters become homeowners for more than a century. In this guide to choosing between Fixed-Rate Mortgages and Adjustable-Rate Mortgages (ARMs), we put our expertise and knowledge of the Vermont and New Hampshire markets to work for you. Here’s what you need to know to make an informed decision.

What’s the difference between fixed-rate and adjustable-rate mortgage (ARM) loans?

The most important difference between the two is the consistency of the interest rate. As the names of the loans suggest, the payment of principal and interest on a fixed-rate mortgage will never change. You’ll keep the interest rate you signed up for throughout the life of the loan. That means your monthly payment of principal and interest should stay the same, except for when your real estate taxes or homeowner’s insurance premiums rise. Your payment may change if you have an escrow for your real estate taxes or homeowner’s insurance.

On the other hand, what we often think of as an ARM loan is really a hybrid of the two, often with an introductory fixed-rate period and then annual rate adjustments based on the terms of the loan.

ARMs may have a lower introductory rate than fixed-rate loans. However, ARM borrowers risk rising rates (and payments) after the introductory period ends. That’s why many articles on ARM loans recommend them to buyers who don’t plan to stay in the home long-term. If you plan to sell the house at the end of the initial fixed-rate period, you may decide the lower rate is worth the risk. You can also refinance an ARM into a fixed-rate loan, but you’ll have to pay closing costs again. And what if the real estate market slows down and the value of your home falls, or you can’t sell it as quickly as you hoped? This is why ARM loans aren’t always the great deal that some online articles make them out to be.

The main risk with a fixed-rate loan is that rates will fall and you’ll be stuck with a higher rate. However, there isn’t much chance of this when the United States is in a low-rate environment. No one can predict the future, so it’s better to focus on your current situation. For example, if you can afford the monthly payments on a 15-year loan, you may find that the fixed rate is comparable to the introductory rate on an ARM loan.

Of course, your interest rate and loan term both affect the size of your monthly payment, which affects the total amount you get approved for. If this is a concern for you, we recommend talking to an experienced loan officer to weigh the pros and cons of your particular situation.

Finally, it’s important to know that you can choose between a fixed or adjustable-rate mortgage regardless of the loan type:

• Conventional: The standard mortgage loan.
• FHA: Insured by the Federal Housing Administration, this type of mortgage can have a lower down payment.
• VA: The Department of Veteran’s Affairs insures mortgages with up to 100 percent financing for eligible veterans, service members, and surviving spouses.
• Jumbo: A mortgage with a principal higher than the conforming loan limits set by Fannie Mae and Freddie Mac.

How do Fixed-Rate Mortgages Work?

After the creation of the Federal Housing Administration (FHA) in 1934, the 30-year fixed-rate mortgage was introduced, putting homeownership within reach of many more Americans across economic classes. In contrast, ARM loans only date back to the early 1980s.

Today, the majority of new mortgage loans have a fixed rate. This type of mortgage is pretty straightforward and easy to understand:

• The rate doesn’t change during the life of the loan.
• Fixed-rate loans are fully amortizing, which means the total principal and interest will be paid off at the end of the loan term.
• Your monthly payment of principal and interest will stay consistent throughout the mortgage term.
• In the beginning, more of your monthly payment is allocated to interest; in time, more of it will go toward the principal. Regardless, the total amount is stable.

As you can see, fixed-rate loans provide payment predictability regardless of what happens in the economy. If rates rise, you get to keep your lower rate. The consistent monthly payment is easy to budget for and, as your household income increases, you can put extra money toward your mortgage to pay it off faster if you wish.

How do ARM loans work?

Adjustable-rate mortgages are a bit more complicated. Here’s a breakdown of their four main components:

• Adjustment Period: The frequency with which the rate adjusts up or down based on the index, margin, and lifetime caps. One year (as in a “5/1” ARM) is the most common adjustment period.
• Index Rate: ARMs are tied to an external (not controlled by the lender) market-related interest rate like the 1 year US Treasury rate as published in the Wall Street Journal. There are several for lenders to choose from, but the most important thing for you to know is that the fluctuation of your ARM’s index rate determines the movement of your own rate.
• Method of Adjustment: This is the way your mortgage payment is re-calculated after a rate adjustment. The most common method of adjustment is to raise or lower the payment according to the change in rate, in order to ensure that the loan is paid off by the end of the remaining loan term. Chances are, if your rate adjusts higher, your monthly payment will increase. If your rate goes lower, your monthly payment will decrease.
• Margin: This is the amount added to the index rate to calculate your overall rate. For example, if the margin is 2.75, then 2.75% would be added to whatever the index rate is to arrive at the interest rate.

While these four features represent the core components of the Adjustable-Rate Mortgage, the modern ARM is typically a hybrid with two additional terms:

• Interest Rate caps: A limit on how high the interest rate can go over the life of the loan.
• Interest Rate floor: This is the minimum interest rate on the loan over the life of the loan. The rate will never go below the floor.
• Initial Rate Discount: This is what we’ve referred to above as the introductory fixed rate. For example, let’s break down a 1 year US Treasury 5/1 2/2/6 ARM. The index is the 1 year US Treasury. The 5 represents the number of years the rate will be fixed at the initial rate. The 1 means that the interest rate will adjust annually after the first 5 years. The first 2 represents the maximum percentage interest can increase or decrease at the first adjustment period after the first 5 years. The second 2 represents the maximum percentage interest can increase or decrease every year thereafter. The 6 represents the maximum percentage interest can increase or decrease over the life of the loan.

As you can see, choosing an ARM loan requires more upfront research and consideration to make sure you end up with an overall loan rate and terms that work for you.

Mortgage Pros and Cons

Let’s look at the most important considerations in your mortgage decision-making process. We’ll identify the pros and cons of each mortgage type in the context of these factors.

Interest Rate Risk

With a fixed-rate mortgage, the borrower has peace of mind knowing their interest rate will never change during the life of the loan. The borrower reaps the benefit when rates increase, but is potentially overpaying when rates decline. With an ARM, there is no interest rate risk after the initial fixed period as the rate is always adjusting to the current market conditions. Therefore, the borrower is never over-paying or getting a better deal than the current market rate.

Monthly Payments

As we’ve shown, an ARM may come with a lower monthly payment in the beginning, but fixed-rate loans offer payment stability. Whatever type of mortgage you choose, the loan term has a lot to do with the size of your monthly payment. For example, with a 15-year loan you’ll pay off the mortgage sooner and pay less interest overall, but your monthly payments will be higher. A longer term, such as 30 years, would make the monthly payments lower.

Early Pay-off

Some people have a financial goal of paying off their mortgage loan early. If this is you, keep in mind that this is easier to do with a fixed-rate mortgage. It’s possible with an ARM, too, but more complicated calculations are required, given the adjustment method and other terms of an ARM.

Interest Rate

Rates for new mortgages are updated daily—you can check Union Bank’s current rates for Vermont and New Hampshire here.

The Takeaway

Fixed-rate mortgages have been more popular than ARMs since the Great Recession of 2008. In general, ARMs tend to be more common in metro areas with expensive real estate. That is likely due to homebuyers who need to qualify for a larger loan in order to buy where they live. In Vermont and Northern New Hampshire, an ARM is typically used if a borrower plans on selling or refinancing on or before the initial fixed period, thereby benefiting from the lower ARM rate and payment when compared to a fixed rate loan.

Stay local and go far with a mortgage from Union Bank!

As a longtime community bank, we’ve seen it all and offered a steady hand to guide our customers through the latest trends and economic ups and downs. We believe homeownership benefits both the individual and family as well as the larger community. That’s why we love helping our customers through the mortgage application process on their way to becoming homeowners. Find out why more Vermonters choose us for their mortgage than any other bank.

Want to learn more about mortgages? Check out our guide to VT and NH Homebuyer Assistance Programs, Vermont Homebuyer Guide, and The Home Buyer’s Guide To New Construction In Northern New Hampshire.

Ready to get started? You can apply for a mortgage online or contact our team of friendly and experienced mortgage lenders for help finding the right home loan.