Loan time - choosing between Fixed Rate vs Adjustable Rate


One of the first decisions you must make is whether to get a fixed rate mortgage or an adjustable rate mortgage.  There are various factors that play key roles on deciding which one is a better fit for you. This guide will discuss those factors and although it doesn't tell you which one to choose for your situation, it should give you an idea on how to choose one after thinking your financial situation through thoroughly.

Fixed Rate Mortgages
A Fixed Rate Mortgage comes with a set interest rate (based on your credit history and score) that does not change through the life of the loan.  Although the amount of your monthly payments going to the principle and interest varies from month to month, the total monthly payment remains the same.  This is the most commonly used and preferred method for loan seekers, as it doesn't add complications to the budgeting process.

Take for example, a mortgage for $200,000 with a 6% interest rate for 30 years.  The table below reflects the allocation of the payments to the principle and interest, also known as the amortization schedule.

Payment Principle Interest Principle Balance
1. $1,199.10 $199.10 $1,000.00 $199,800.90
2. $1,199.10 $200.10 $999.00 $199,600.80
3. $1,199.10 $201.10 $998.00 $199,399.70

As you can see, much of the initial payments are paid toward the interest portion of the loan.  This switches with the later payments where much of the payments will go toward the principle portion of the loan.  Although theoretically you can have a mortgage for any fixed number of years, it is rare to see anything other than 15, 20, or 30 years.  Of the three terms, 30 year mortgages are the most common due to monthly payments being the lowest.

Summary characteristics of a Fixed Rate Mortgage
  • Stability - You make identical payment amounts every month.  This makes budgeting much easier than having to prepare for rate fluctuations.
  • Simplicity - It is very easy to understand the terms and payments.  It consists little more than your principle, term length, and interest rate.  You get a simple monthly payment amount with that.
  • Qualification - It is usually harder to get approved for a Fixed Rate Mortgage than a Adjustable Rate Mortgage, as the payments can be substantial especially during the period of high interest rates.
  • Refinance Fees - If rates have gone down and you want to get your mortgage interest rate lowered, you must undergo a mortgage refinance.  Fees will incur when you do this.

Adjustable Rate Mortgages (Floating Rate, Flexible Rate, Variable Rate)
An Adjustable Rate Mortgage, ARM (also know as Floating Rate Mortgage, Flexible Rate Mortgage, or Variable Rate Mortgage) is designed to have the interest rate fluctuate throughout the term of the loan.  The initial interest rate on an ARM is set below the market rate on a comparable fixed rate loan, and then resets to the higher rate after the period.  ARM's have been popular in the last 10 years as property prices rose across the board.  It was estimated that one out of every five mortgages in the San Francisco Bay Area between 2004 and 2008 was adjustable!

ARM's typically come with a fixed rate period, such as a 1-1, 3-1, or 5-1 ARM.  That means the rate is fixed for the first X years (X-Y structure, X is known as the initial period and Y known as adjustment period) and then resets every Y years.  The interest rate will follow a certain market index.  You ARM will also come with a margin: the rate the lender charges you on top of the index rate, such as one-Year T-Bill plus 2%, for which the one-year T-Bill is the index rate and the 2% is the margin.  It is always smart to figure out which index the lender goes with early on.

Summary characteristics of a Variable Rate Mortgage
  • Flexibility - You don't have to refinance your mortgage in the event that interest rate falls.  Your loan interest rate will be lowered automatically and you don't have to worry about the refinance fees.
  • Lower Introductory Payments - Many Variable Rate Mortgages come with some sort of promotional periods that will come with a lowered rate for the first couple of years.  This is especially attractive for prospective homeowners when housing prices are high and are having a hard time qualifying for a traditional fixed rate mortgage.
  • Qualification - It is usually easier to qualify for a Variable Rate Mortgage than a traditional Fixed Rate Mortgage because payments are lower. 
  • Common Payment Shock - some people will experience this expected shock at the end of the introductory period.  This is when the interest rate resets from the promotional introductory rate to the variable rate.

Deciding on Fixed vs. Adjustable
A fixed rate mortgage is typically recommended for those people that already have a steady income stream and planned on staying at the house for an extended period of time.  This is particularly well suited for people with families and jobs that will enable them to stay in that same geographical location for years.  If you have a tight budget that has very little wiggle room, you should definitely consider the fixed rate route, as long as you have strong credit and qualify for the loan.

An adjustable rate mortgage is probably a better option for younger crowd that is expecting a rise in their income in the near future.  People that are only in a place temporarily and/or expecting to move around or up the payscale will also find this attractive.  This plays well with the lowered rates during the initial period.  Since the loan qualifications are less strict, an ARM is also the choice for someone with problems getting qualified for the traditional fixed rate mortgage. 

You may end up choosing either a fixed rate mortgage or an adjustable rate mortgage.  The key is that you know what you are getting into and not be surprised by costly mistakes.