For most individuals, buying a house will be the largest financial transaction that they ever conduct. Most individuals will need to borrow funds via a mortgage in order make this purchase. So, how should you choose between a fixed or adjustable-rate mortgage?
Like most personal finance-related questions, the type of mortgage that you should consider will depend on the state of your finances. Understanding the various shapes and sizes in which mortgages are packaged will help you to make the right choice for you.
What is a Mortgage?
A mortgage is a loan that is directly tied to the purchase of a real estate property. The asset itself helps to support the loan, as lenders have the added security of knowing that they can repossess the property if the borrower runs into trouble while paying it back.
The size of the mortgage that you can obtain is based on your income, your prospective down payment, credit history, and the surrounding macroeconomic environment. It follows that individuals with a strong credit history, high monthly income, and a decent amount saved up to devote towards a down payment will enjoy better terms than those with weaker finances. However, the interest rates in the market will also have an effect, for everyone.
Over the long-run, the size of the loan and the interest rate charged can have a significant impact on the total cost of the mortgage. For instance, even a 1% difference between interest rates over a 30-year mortgage can translate into thousands of dollars over the lifetime of the loan.
The TipRanks’ mortgage calculator will allow you to experiment with different values, which can help you to understand how the contours of the loan can make a huge impact on your financial bottom line.
It is important to understand how interest rates will affect your loans before deciding whether to go with a fixed-rate or adjustable-rate option.
What are Fixed-Rate Mortgages?
Fixed-rate mortgages are exactly what they sound like. You will lock-in a particular rate, which will last for the entirety of the loan.
The advantage of doing so is fairly straightforward: you have the benefit of certainty throughout your loan. Regardless of whatever else happens in the market, your interest rates will remain the same. This allows you to pursue your long-term planning, without any worries that your monthly mortgage costs will jump up.
Lenders base the interest they charge their customers on both the particulars of the prospective client, as well as on the macro economic environment at the time that the loan is originated. The Federal Reserve sets the range that banks must pay to borrow money overnight via the Federal Funds Rate (also known as the Fed rate). When this goes up, it is more expensive for banks to borrow money, and these costs are passed along to the client.
Once you have secured a fixed-rate mortgage, these macro considerations will not have any influence on your monthly mortgage payments.
However, this is a double-edged sword. What can go up, can also go down, and you could end up locking in a higher interest rate. (When this happens, you can elect to refinance, though there are risks with this approach as well.)
What are Adjustable-Rate Mortgages?
Adjustable-rate mortgages (also known as variable-rate mortgages), tend to start off with a slightly lower fixed-rate for a certain period of time. This is usually between 3- to 10-years in range.
After the initial period elapses, the adjustable-rate mortgage will then re-set. The cadence at which the recalculation happens is dependent on the details of your mortgage, and it can happen biannually, once a year, or another predetermined interval of time.
The amount that the adjustable-rate mortgage is recalibrated will also vary based on the confines of the loan agreement that you have secured with your lender. In general, an adjustable-rate mortgage is pegged to a particular index.
The Secured Overnight Financing Rate is becoming the go-to rate index for these adjustable mortgages. The SOFR is the amount that it costs to borrow in dollar-denominated loans overnight. Because it is based on past transactions, it is less prone to manipulation and is therefore becoming more and more popular.
In addition to the chosen rate, a margin is also agreed upon in the loan agreement. This will be a certain percentage above the SOFR at the time of the recalibration. For instance, if your margin is 1.5% and the SOFR is 3.5%, then your new interest payments will be 5.0%.
There are also generally caps on the amount that your loan can increase at each timeframe and during the lifetime of the loan. These ceilings will prevent the rate from jumping up too dramatically.
Is it Better To Go With a Fixed- or Adjustable-Rate Mortgage?
The difference between a fixed- and an adjustable-rate mortgage is the level of uncertainty, and the price. In essence, lenders can offer lower rates in the beginning of an adjustable-rate mortgage because they are not taking on the risk of future interest rate fluctuations.
Therefore, an adjustable-rate mortgage can make the most sense for those who fit the following criteria:
(1) Fast turnaround: Individuals looking to stay in their current mortgage for a short amount of time. Because the rates start lower, this option can make sense for those who are either planning to sell their home or refinance after only a few years into their mortgage.
(2) Higher risk tolerance: Individuals who can live with the uncertainty, or will not be impacted too greatly from having a higher monthly payment. The risk of higher interest rates will not concern them, and they will hope that the environment will shift rates in the lower direction in the years ahead. (Or, they are not bothered by the potential to look into refinancing options.)
(3) Paying off quickly: Individuals who are going to try and pay off more of the loan principal in the first few years. The lower interest rates in the first part of the loan tenure will give these home owners an opportunity to pay off more of the loan principal. The interest you owe on your loans is only due on the balance remaining. Therefore, the more this gets paid, off the less you will owe in interest.
As always, meeting with a financial or mortgage professional can help you to understand the ins-and-outs of this decision, and which direction might be best for you.
Conclusion: Choosing Your Terms
Everyone will have a different level of financial comfort, and making the decision between a fixed-rate and an adjustable-rate mortgage will depend both on your finances and risk profile.
The choice boils down to one based on certainty versus the unknown. Mortgages are a big deal. It is well worth taking the time to think about the size, length, interest rates, and every other aspect that goes into making this decision.
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