Fixed Rate vs. Adjustable Rate Mortgages
There are two major rate types, and they’re incredibly different. If you learn one thing here, it should be this!
- Fixed rate loans – the interest rate for the loan is set for the life of the loan & does not change.
- Adjustable rate loans – the interest rate is set for a period of time, and then adjusts regularly over the life of the loan. Also often called ARMs (adjustable rate mortgages.)
This difference is huge. With a variable interest rate loan, as your interest rates adjusts, your monthly payment adjusts with it. This was the problem for many during the 2008 housing crisis – the interest rate on their loans adjusted, and suddenly they couldn’t afford the monthly payments, which lead to foreclosures.
Let’s use a much smaller purchase to explain how this works. Imagine you wanted to buy a car. You go into the dealer, you negotiate your price, and they give you a loan. It’s a variable rate loan, and your payment is $200 a month to start. Let’s say your payment will stay the same for 3 years, and then will begin to adjust. You figure by the time your payment changes you’ll figure out something else. Maybe you’ll get a raise, or maybe you’ll refinance the loan. Maybe you’ll want a new car by then! Anyway, that’s a problem for future you.
Well, 3 years go by, and you’ve decided you want to take some time off from work and spend time with your family. That $200 payment raises to $275, and now you can’t get a new loan because you aren’t working. On top of that your maintenance costs go up, your brakes are finally wearing thin and it’s time for a new set of tires. Now what? You are either left to pay these higher payments for as long as possible, or you end up selling your car. This is basically what happens, on a much larger scale, when some people get adjustable rate mortgages and don’t understand the mechanics of how they work.
Are adjustable rate mortgages bad?
Adjustable rate mortgages aren’t all bad though, they can actually be pretty useful if you understand how they work. You just need to understand how they work and make an informed decision to use them responsibly.
Adjustable rate loans usually have a few basic components. At the start, they have an artificially low interest rate. This “intro rate” can last as little as 1 month or as long as 5 years. After the intro period, the interest rate will adjust, and will continue to adjust every month, quarter, year, 3 years or 5 years, however long your adjustment period is.
The adjustment is tied to a market index – it will adjust as the value of some other thing fluctuates, usually the LIBOR index, the Fed Funds Rate, or the Treasury Bills rate. If that index goes up, your rate goes up, and your monthly payment goes up. If it goes down, your rate goes down, and your payment actually goes down with it (that part is kind of cool…)
Because of the low interest rate during the intro period, ARMs can be great short term loans. If you plan on being in the property for a short period of time (ex. you’re going to move before the interest rate adjusts) then an ARM may work well for you. It will usually offer a significantly lower monthly payment.
In certain scenarios an ARM can work wonders for you, leaving you with lower payments and more equity. But with the Fed raising rates 8 times since 2015, and the fact that it’s unclear if they’ll continue to rise, there’s a chance an ARM loan taken out now will adjust to a higher rate at the end of the intro period.
Obviously, we highly recommend doing your own research before jumping into an ARM. To learn more about whether an ARM or variable rate loan may be right for you, here are some resources to start with:
- The Pros and Cons of Adjustable Rate Mortgages by NerdWallet
- A cautionary tale from 2006 – Nightmare Mortgages by Bloomberg
- 3 Reasons an Adjustable-Rate Mortgage is a Great Idea by The Motley Fool.
- The Wikipedia article for Adjustable Rate Mortgages