The primary difference between a fixed-rate and a variable-rate mortgage (also called an adjustable-rate mortgage or ARM) is summed up in their names. A fixed-rate mortgage will give you the same interest rate for the life of the loan, whether it is 10, 15, or 30 years. With a variable-rate mortgage, the interest rate can change while you are holding the loan. Many home buyers are uncertain which kind of mortgage they want, but there is no easy, one-size-fits-all answer to that question. The kind of mortgage that is best for you depends on your financial situation, the economy, how long you plan to own the house, and other factors.
Understanding Fixed-rate Mortgage: While applying for a mortgage can be complicated, the idea behind it is simple. No matter how much mortgage interest rates rise or fall in the future, your interest rate will remain the same, making it easy to budget for the future.
Understanding Variable-Rate Mortgages: Variable-rate mortgages are more complicated. They usually start at a certain fixed interest rate for a period of time (anywhere from one month to five years). However, once that initial period is over, the interest rate can go up or down depending on current economic conditions. While this sounds like a potentially unstable situation, a consumer can be protected from a sharp and sudden increase in interest. One way is for the mortgage contract to spell out a cap on how quickly the interest rate can rise – for instance no more than 2% a year – or it can set a lifetime cap so you know your mortgage will never go above a certain limit, such as 10%. The contract also explains how frequently the interest rate will change, although it is most common for variable rate mortgages to adjust once a year.
Advantages of Fixed-Rate Mortgage: Fixed-rate mortgages give peace of mind and financial security. If you are purchasing your house during a time when interest rates are low, a this kind of mortgage allows you to lock in those low rates for 10-30 years. Because the concept behind fixed-rates mortgages is simple, they are easy to understand; your mortgage contract does not need to spell out caps and adjustment periods, etc. However, if mortgage rates decrease significantly during the life of the loan, fixed-rate mortgage holders cannot take advantage of the lower rates without incurring refinancing charges.
Advantages of Variable-Rate Mortgages: Variable-rate mortgages allow you to borrow money at a lower initial interest rate, so they are a good option for cash-strapped home buyers and permit you to buy a bigger house. If you plan to own your house for only a few years, a variable-rate mortgage makes sense because you will enjoy lower interest and payments – and you will move before your rate increases. Homeowners can also take advantage of drops in interest rates without needing to refinance their mortgage. On the other hand, variable-rate mortgages are more complicated and a home buyer must understand the caps, adjustment periods, and other factors he or she is agreeing to.