Affordability is a major issue when it comes to buying a home, so it's worth it to think strategically about financing—particularly now that interest rates are so high.
Here, we'll look at the relative advantages and disadvantages of fixed-rate and adjustable-rate mortgages.
A fixed-rate mortgage locks in both your interest rate and your 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 also available.
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 for those who 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 a guessing game with interest rates.
An adjustable-rate mortgage (ARM) has a fixed interest rate for a specified initial term—for example, five years—after which the interest rate may change in line with prevailing interest rates (based on the terms of the loan). If you're considering an ARM, it's important to read all the terms of the loan. Things to consider when looking at an ARM include:
- Lower initial rate: During the initial fixed period, the interest rate is usually lower than what you'd pay for a fixed-rate mortgage. That can save you money, assuming the duration of the fixed period aligns with your plans.
- Interest rate caps: To protect against significant interest rate moves after the initial fixed period, many ARMs set limits on how much your rate can increase or decrease during any given interval (adjustment cap) and over the life of the loan (lifetime 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. If they fall, you should also know how low it can go. You could benefit from lower payments, but an interest rate floor may cap how much savings you potentially receive.
- Interest-only options: Some ARMs offer an interest-only payment option to lower your initial monthly payments even further. However, it's 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 before the initial interest rate resets—such as pay off the loan, sell the home, or refinance the loan. 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 interest rates change.
Whether you choose a fixed-rate mortgage or an ARM, don't be enticed into borrowing more than you can afford. Plan for something that 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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