Should I get a fixed-rate or adjustable-rate mortgage?

Last year hit the world economy like a double-edged sword. As the coronavirus pandemic swept across the United States and the rest of the world, unemployment rates jumped and markets shifted. While much of what 2020 dealt was negative, the pandemic did provide one significant benefit to potential home buyers: historic low-interest rates.

In March 2020, the Federal Reserve cut interest rates to a range of 0% to 0.25% to shield the economy from the impact of COVID-19. The lowered rates trickled down to consumers who are now seeing low mortgage rates.

With the current low mortgage rates, some buyers want to decide what type of mortgage loan would be most beneficial. Current rates are likely to go up over the next several months to years, so this may be the best time for buyers to take advantage of the lowest mortgage rates possible.

Types of mortgages: Fixed rates vs. Adjustable rates

Mortgage loans fall into two basic categories:

1. Fixed-rate mortgage
2. Adjustable-rate mortgage (ARM)

Both loans charge interest and are available in varying loan terms (i.e., 15-year, 20-year, 30-year), but there are some significant differences.

1. Fixed-rate mortgage

In a fixed-rate mortgage, the interest rate stays the same for the loan's life. The only way your interest rate would change is through a refinance.

2. Adjustable-rate mortgage (ARM)

An adjustable-rate mortgage applies the interest on the loan balance at varying interest rates over the loan's life. The rates vary based on a specific index and the ARM margin. The lender will typically offer lower margins to customers with higher credit scores. Additionally, many lenders provide introductory rates, which generally are incredibly competitive. The initial rate is usually fixed for a set time before switching to an adjustable rate.

There are limits on how much interest can change each year and how much it can change in total (there's a cap to the maximum interest rate your lender can charge, no matter what happens in the market).

HOW TO PAY OFF YOUR MORTGAGE EARLY

Should I get a fixed-rate or adjustable-rate mortgage?

Pros

Fixed-rate mortgage: The obvious benefit of a fixed-rate loan is that you know how much you're going to pay every month for the life of your loan. A fixed-rate loan makes budgeting easy. Right now, interest rates are at historic lows. At publication, the average 30-year fixed-rate mortgage is 2.65%, and the average 5/1-year ARM is 2.75%, according to Freddie Mac.

Adjustable-rate mortgage: Adjustable-rate mortgages are a good option for buyers who plan to move or refinance their mortgage within 10 years. Most buyers won't reach the cap interest rate on their loan within that time. Additionally, people may qualify for a higher adjustable-rate mortgage before they are eligible for a fixed-rate loan.

Adjustable-rate loans have several options that offer flexibility, including interest-only ARMs, payment-option ARMs, and hybrid ARMs.

Luckily, there are free online tools available that make refinancing your mortgage easy. By entering some simple information, you can pre-qualify in minutes.

WHY IT'S A GOOD IDEA TO REFINANCE YOUR MORTGAGE WHILE RATES ARE LOW

Cons

Fixed-rate mortgage: Fixed-rate mortgages have downsides too. When interest rates are higher, they are more challenging to obtain, especially if you have any credit issues. Additionally, while fixed-rate loans are ideal when interest rates are low, buyers with an adjustable-rate mortgage could see lower rates and lower monthly payments when the market changes. The only way to reduce your interest rate with a fixed-rate mortgage is through a refinance.

If you’ve determined that a mortgage refinance makes sense, remember to compare rates online to find the right lender for your needs and budget.

REFINANCE YOUR MORTGAGE BEFORE RECORD LOW RATES DISAPPEAR

Adjustable-rate mortgage: The major drawback of an adjustable-rate mortgage is that your monthly payments could change after the introductory period. Your monthly payments could adjust multiple times over the life of the loan, making it challenging to maintain a steady budget.

If you're considering an adjustable-rate loan, ask your lender about the lifetime cap. Most lenders have a cap of 5 to 6% (which means your interest rate cannot increase more than 6% over the life of your loan). If your introductory rate is 3%, the max interest rate you could pay, in this case, would be 9%. Use an online mortgage calculator to determine if you can afford the highest option. At the very least, you'll have a complete picture of what your payments could look like if the market shifts dramatically.