Pros and Cons of Fixed and Adjustable Rate Mortgages

First-time home buyers often struggle to understand the differences between various types of fixed-rate, adjustable-rate and hybrid mortgages. One way to simplify these comparisons is to review the basic elements of each type of home loan. Here’s a summary:

Pros and cons of fixed-rate mortgages
The chief advantage of a fixed-rate mortgage is that the interest rate and monthly payments will remain exactly the same for the entire lifetime of the loan, be it 15 years or 30 years. There is no uncertainty with this type of mortgage as neither the interest rate nor the payment will ever be higher or lower than they were when the loan was originated. Fixed-rate mortgages also are easier to understand than more complicated adjustable-rate and hybrid mortgages.

Pros and cons of adjustable-rate mortgages
The chief advantage of an adjustable-rate mortgage, or "ARM," is that you may have lower initial monthly payments. This is because ARMs often offer a low initial interest rate on the loan. You therefore have the potential to save money in lower interest costs if the interest rate on your ARM remains lower than the rate available for a fixed rate mortgage.

Despite those advantages, ARMs are inherently more risky than fixed-rate mortgages. If the initial interest rate on an ARM is lower than the fully adjusted rate, the rate and the monthly payment can increase significantly at each adjustment period. Over time, an ARM can turn out to be more costly than a fixed-rate loan would have been. Since there is no way to predict future interest rates, borrowers should pay considerable attention to just how high their monthly payments can get.

Pros and cons of Hybrid ARMs
A hybrid ARM offers a compromise of sorts between the advantages of a fixed-rate loan and the advantages of an ARM. The interest rate on a hybrid is fixed for a set number of years before the first adjustment. Borrowers who intend to move or refinance their mortgage within the fixed-rate period may benefit from the lower initial interest rate that may be offered on a hybrid ARM. The longer the fixed rate lasts, the less risky the loan will be and the higher the initial interest rate will be.

It’s also a good idea to pay attention to the spread between the interest rates on various loan products. For example, the spread between a fixed rate of 6.5 percent and an adjustable rate of 4.5 percent would be 2 percent while the spread between a fixed rate of 6.8 percent and an adjustable rate of 4.2 percent would be 2.6 percent. The larger the spread is, the more potential savings the riskier ARM loan offers over time. When the spread is narrow, a fixed-rate loan is generally considered more attractive.

For more help choosing the right home loan for you, read our article How to Choose the Right Loan.