For most people shopping for a home, price is just the starting point. 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. Other reasons to consider a fixed-rate mortgage include:
- Predictable budgeting: Your repayment obligations will be clear.
- Interest rate stability: Your payment will hold steady, even if interest rates rise.
- Flexible terms: Most borrowers opt for a 30-year mortgage, but shorter terms, such as 15 or 20 years, may be a better fit for your goals.
Fixed-rate mortgages can be appealing if you think rates are lower now than they will be in the future. 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) is generally a hybrid, with a fixed interest rate for a specified initial term—say, five years—after which the interest rate may reset, or fluctuate, typically depending on prevailing interest rates. A 5/1 ARM, for example, offers a five-year fixed rate of interest, after which the rate can reset annually.
ARMs typically offer lower initial monthly payments. As a result, an ARM may make sense if you would like greater cash-flow flexibility in the near term and/or think rates might decrease in the future. Other reasons to consider an ARM include:
- Lower initial rate: The interest rate during the initial fixed period is generally lower than that of a fixed-rate mortgage, which can save you money over the short term.
- Interest rate caps: To protect against rising interest rates, many ARMs offer limits on how much your rate can increase during any given reset period and over the life of the loan. You should nevertheless budget for the maximum interest rate your loan allows once your fixed rate period ends.
- 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
Although ARMs can offer attractive initial payments, be certain to budget for potentially higher rates once the initial fixed-rate period ends. Don’t assume that you can refinance or sell your home before rates change. And whether you choose a fixed-rate mortgage or an ARM, don’t be enticed into borrowing more than you can afford.
1Interest-only mortgages have an initial interest-only payment period followed by a fully amortizing payment period that includes both principal and interest.
What you can do next
A financial plan can help you navigate major life events, like saving for the down payment on a home or a renovation.