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 rates near 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 steady and clear. 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. With rates near historical lows, locking in today’s rates for the long term could make sense for many borrowers.
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 (within limits) depending on prevailing interest rates. A five-year ARM, for example, offers a five-year fixed rate of interest, after which the rate can change every six months, but by no more than +/- 1 to 2%. Reasons to consider 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 rates moves, 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 with a specific purpose in mind, such as paying off the loan, selling the home, or refinancing the loan within the initial fixed-rate period. However, borrowers should be willing to take on the risk that interest rates could rise, and shouldn't assume that they can 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.