Whether you’re in the market for a new home or looking to refinance an existing mortgage, it’s reasonable to assume your goal is to make the smallest payments possible.
While payment size is undoubtedly a factor, it shouldn’t be your only consideration when evaluating mortgage loans.
In the home buying or refinancing process, you’ve likely come across fixed-rate and adjustable-rate mortgage options. While there are some common arguments regarding which one is more beneficial for homeowners, it’s worth taking a moment to consider the pros and cons of each.
The results may surprise you.
Is a fixed-rate or adjustable-rate mortgage more advantageous? Let’s dive in.
What’s a Fixed-Rate Mortgage?
When choosing a fixed-rate mortgage, the interest rate is locked in for the life of the loan. It will be the same rate the day you close on the house as when you make your final payment (or refinance). No matter the market or economy, your rate will stay put.
For example, the Federal Reserve has continued to raise rates throughout 2022 to combat high inflation. As a result, mortgage rates more than doubled in the span of a year—from an average of 3% in September 2021 to an average of 6.7% by the end of September 2022.1 If you locked in a fixed-rate mortgage of 3% last year, this swift rise in rates doesn’t impact it.
A fixed-rate mortgage is helpful if you can snag a below-market rate. It provides certainty for homeowners, which helps manage cash flow and prepare budgets. As a general rule of thumb, fixed-rate mortgages tend to benefit those who plan on staying in their homes long-term—typically 10 years or longer.
What’s an Adjustable Rate Mortgage (ARM)?
Unlike a fixed-rate mortgage, an ARM will alter the interest you pay based on what’s happening in the market. ARMs typically start with lower interest rates than fixed-rate mortgages, but the rates will change based on index data.
ARMs typically have an introductory period, where they act much like a fixed-rate mortgage. For a predetermined number of months or years, the interest rate will stay the same—no matter what’s happening in the markets.
Once the introductory period ends, the interest rate begins varying. In periods of rising interest rates, that can mean higher monthly payments.
As you look into ARMs, you’ll find that some include caps on how high the interest rate can go or drop. In an environment of rapidly rising rates, a rate cap is an important feature to look for in a mortgage.
During the introductory period, you may enjoy the lowest payments of the life of the loan. Consider using this opportunity to put more money toward paying the loan’s principal.
Most mortgage companies allow borrowers to apply for additional monthly payments, specifically toward the principal amount. Check with your lender to see if they allow this and how to set them up.
ARMs Have a Bad Rep, But They Could Benefit The Right Homebuyer
The introductory fixed period of an ARM provides some sought-after stability when settling into a new home and mortgage. But once it expires, your rates could double or even triple. When that happens, your monthly spending could take a hit. It’s for this reason ARMs tend to have a bad reputation.
The key to using an ARM to your advantage is considering how long you anticipate being in your home. Based on the national average, your timeline might be shorter than you think. In 2021, 61% of all home sellers under 42 were in their previous homes for less than eight years.2
If you think you may live in your home for less than a decade, you could land a low initial rate through an ARM and move out (or refinance) before the introductory period expires. Depending on how rates are trending, an ARM could save you thousands of dollars a year in lower monthly payments.
Lower Payments Are Always Better, Right?
This is a common fallacy when securing mortgage loans. On the surface, aiming for the lowest payment possible makes sense. But in reality, lower monthly payments tend to stretch out the length of the loan and actually increase the total amount you’ll pay in interest over time.
Say you obtain a $450,000 mortgage on a $500,000 home. If you choose a 30-year fixed mortgage at 5%, your monthly rate (only counting principal and interest) comes to $2,416. A 15-year mortgage with the same rate comes to $3,559 per month. While the monthly payments are smaller on a 30-year mortgage, you’re paying $229,140 more in this scenario than if you’d gone with a 15-year mortgage.
Many homebuyers consider a shorter-term fixed mortgage to be a helpful forced savings plan to build home equity. The accelerated paydown of principal from larger monthly payments leads to lower interest payments over the life of the loan.
Financing Your “Forever” Home
If you’re looking to buy your “dream home,” you likely plan on staying there long-term. Sticking with a fixed-rate mortgage might make the most sense if that’s the case. That way, you won’t have the uncertainty and unpredictability of ARMs after the low-interest period expires.
Finding The Right Mortgage for You
As you consider your loan options, identify your homeownership goals.
- Are you a young couple looking for a starter home, or is it time to settle into your forever home?
- If you or your spouse move around every few years for work, do you plan on selling and buying again in five years?
All these factors can help determine whether a fixed-rate or adjustable-rate mortgage is right for you.
Feel free to reach out to discuss your homebuying goals further. Having these conversations is helpful for us to create a financial strategy that’s best suited for your needs today and down the line.
Craig Toberman is the Founder of Toberman Wealth – a fee-only, fiduciary financial advisor based in St. Louis. He assists families and businesses with strategic financial planning and long-term wealth management. He has over a decade of experience in financial services and has crafted custom financial plans for hundreds of families and businesses.
Craig received a Bachelor of Science (B.S.) degree in Agricultural and Consumer Economics from the University of Illinois and a Master of Business Administration (M.B.A.) degree in Finance from Saint Louis University. He is a Certified Financial Planner (CFP), Chartered Financial Analyst (CFA) charterholder, and Certified Public Accountant (CPA).
Craig is a member of the National Association of Personal Financial Advisors (NAPFA), Fee-Only Network, and XY Planning Network.
Craig lives in the greater St. Louis area with his wife, Ally and son, Hank.