For most people shopping for a home, price and location are top considerations. How much a bank is willing to lend—and under what conditions—also plays a role in determining what they can afford. That's why it's important to think strategically, particularly with interest rates moving up from historically low levels.
Let's look at how two different types of mortgages—fixed-rate and adjustable-rate—can serve different types of borrowers, and how their relative advantages can change depending on prevailing interest rates.
A fixed-rate mortgage locks in both your interest rate and monthly payments for the life of your loan, offering the peace of mind that comes with stability. This is the most traditional form of mortgage. Reasons to consider a fixed-rate mortgage include:
- Predictable budgeting: Your repayment obligations will be clear.
- Interest rate stability: Your payment will hold steady for the entire term of the loan.
- Flexible terms: Most borrowers opt for a 30-year mortgage, but shorter terms, such as 15 or 20 years, are available and may be a better fit for your goals.
Key takeaway: Fixed-rate mortgages are a good fit for most borrowers. They are appealing for those who plan to own their home for the long term and want peace of mind knowing their loan repayments will be predictable. If interest rates should fall during the life of the loan, borrowers could consider refinancing, but the goal is to not play the guessing game.
An adjustable-rate mortgage (ARM) has a fixed interest rate for a specified initial term—say, five years—after which the interest rate may change (based on the terms of the loan). If you are considering an ARM, it's important to read all the details. Things to consider when looking at an ARM include:
- Lower initial rate: The interest rate during the initial fixed period is usually lower than that of a fixed-rate mortgage, which can save you money, if your goals align with this period. However, interest rates can go up steadily thereafter.
- Interest rate caps: To protect against significant interest rate moves after the initial fixed period, many ARMs offer limits on how much your rate can increase during any given interval (cap adjustment) and over the life of the loan (life cap). It's best to calculate the maximum interest rate your loan allows for once your initial period ends and be prepared to make any necessary changes with your planning if interest rates should rise.
- Interest-only options: Some ARMs offer an interest-only payment option to lower your initial monthly payments even further. However, it is important to remember that during the interest-only period, your payments will not reduce your loan principal unless you choose to pay more than the minimum billed amount.1
Key takeaway: An ARM may be a good option for those who plan to do something specific—such as pay off the loan, sell the home, or refinance the loan—before the initial interest rate resets. However, borrowers should be willing to take on the risk that interest rates could rise and shouldn't assume that they'll be able to easily refinance or sell the home before rates change.
Whether you choose a fixed-rate mortgage or an ARM, don't be enticed into borrowing more than you can afford. Plan on what fits your budget and goals.
1Interest-only mortgages have an initial interest-only payment period followed by a fully amortizing payment period that includes both principal and interest.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. Please consult with your tax advisor on the deductibility of home equity line of credit interest payments for your specific tax situation.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers are obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed.
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