Fixed-Rate Mortgage vs. Adjustable Rate Mortgage

We already know that a mortgage is one of the biggest expenses that any investor has. It is also common knowledge that the interest rate is the biggest determining factor of the dollar value of each month’s mortgage payments. The interest rate of the mortgage is often the subject of a lot of discussions. This is because the interest rate is where the homeowner gets a choice. Hence, there is a constant discussion to find out about whether it is wiser to choose a fixed-rate mortgage or an adjustable-rate mortgage.

In this article, we will have a closer look at what these different types of mortgage contracts are and how they impact the financial planning process.

Fixed-Rate Mortgages

Fixed-rate mortgages are probably the most uncomplicated type of mortgage loan which is available to homeowners. This is also the reason that most homeowners typically opt for this mortgage. The meaning of a fixed-rate mortgage is that the interest rate on your mortgage loan and, therefore, the dollar amount of your mortgage payment will remain unchanged for the entire tenure of the loan. In America, most loans are for 15 years or 30 years.

Since there is a guarantee that the payments will remain the same throughout the tenure of the loan, homeowners find it easier to budget for such loans. However, this convenience is not free but comes at a cost. The fixed-rate mortgage is usually front-loaded. This means that the interest costs are higher, to begin with. For example, if the prevailing interest rate on an adjustable loan is 2.25%, the fixed-rate mortgage will begin at 2.6%. Hence, it is more expensive by 350 basis points, to begin with!

Hence, the fixed-rate mortgage is suitable for a person who has a stable job and plans to stay in the same house for a long period of time. Since they are likely to stay in the same house, they agree to pay a slightly higher rate in return for the freedom of having a fixed payment.

Adjustable Rate Mortgages

Adjustable-rate mortgages can be significantly more complicated as compared to fixed-rate mortgages. This is because, in these mortgages, interest rates do not remain fixed. Instead, these interest rates vary over the tenure of the loan.

The characteristics of these mortgages can be deciphered from their name itself. For instance, if an adjustable-rate mortgage is called a 5/1 mortgage, this means that the interest rate will remain fixed for the first five years of the mortgage. After the first five years, the rate will reset once every year.

The initial fixed rates offered by adjustable-rate mortgages are lower. Many financial planners believe that this is a marketing gimmick used to induce people to take up more adjustable-rate mortgages. This is because studies have shown that these rates tend to reset higher than fixed rates several times over the life of the loan. As a result, these loans end up being more expensive over the lifetime of a loan.

Another important point to be noted about adjustable-rate mortgages is that the rate of these loans is typically based on an index. This may mean that the loan will be charged at LIBOR + premium. There are limits to the adjustment that can happen in an adjustable-rate mortgage. This is done to ensure that the loans do not become unpayable in a very short period of time.

In most cases, there is a cap on the interest rate hike that can be done in a single year. Similarly, there can be interest rate caps for the initial years. In some cases, the maximum interest rate that can be charged during the lifetime of the loan is also capped.

Adjustable-rate mortgages have a bad reputation since the subprime mortgage crisis. This is because borrowers were induced into taking higher loans using abnormally low teaser rates. This is one of the problems with adjustable-rate mortgages. Since the initial payments are artificially lower, people end up taking a higher loan amount than they would have otherwise taken.

Adjustable-rate mortgages are typically taken by people who do not intend to stay in the house for a long period of time. Such people typically take the loan for a small period of time, take advantage of the lower interest rate, and then later sell off the house. Also, the adjustable-rate mortgage is typically used by people who want to aggressively pay down their principal in the first few years. They pay down the principle earlier, and hence even if the rate resets to a higher amount, they end up paying lower interest.

The fact of the matter is that pretty much nobody can accurately guess the quantum of interest rate movements as well as their timing. This is the reason that a lot of homeowners prefer a fixed-rate mortgage. An adjustable-rate mortgage is a risky strategy. This is because it requires financial discipline as well as it assumes that the market will respond favorably. In the long run, it can have negative consequences if it is not properly managed.