Your mortgage interest rate is important to know because it influences how much you pay each month — and in total. A key factor in determining your interest rate is whether you have a fixed-rate mortgage or an adjustable-rate mortgage.
In the simplest terms, a fixed-rate mortgage means the interest rate on your home loan never changes. On the other hand, the interest rate on an adjustable-rate mortgage can fluctuate throughout the loan term depending on market conditions. While one interest rate type isn’t necessarily better than the other, your financial situation and goals will help you decide which to go with.
Here’s a look at the key differences between fixed-rate and adjustable-rate mortgages, how they work, and how to decide which interest rate type is a better fit for you:
- Is a Mortgage a Variable or Fixed Rate?
- What Is a Fixed-Rate Mortgage?
- What Is an Adjustable-Rate Mortgage?
- Fixed or Adjustable-Rate Mortgage: Which Is Better?
- The Bottom Line on Fixed-Rate Mortgages vs. ARMs
Is a Mortgage a Variable or Fixed Rate?
Mortgages with a fixed interest rate or a variable interest rate have defining characteristics that set them apart. While the interest rates on fixed-rate mortgages and variable-rate mortgages — aka adjustable-rate mortgages — both depend on economic conditions at the time of loan approval, a fixed interest rate stays the same throughout the loan term. With an ARM, the initial interest rate may be lower compared with a fixed-rate mortgage, but it will likely increase after the introductory period.
Other areas where fixed-rate mortgages and ARMs differ are the monthly payment and amortization schedule. The amortization schedule refers to a table that lays out how much you’ll pay each month for your loan, as well as how much of each payment is going toward the principal versus interest.
Here’s a breakdown of a few key differences between these two interest rate types:
|Loan Feature||Fixed-Rate Mortgage||Adjustable-Rate Mortgage|
|Interest Rate||• Interest rate set based on market conditions when you take out the loan|
• Remains the same throughout the life of the loan
|• Interest rate fluctuates based on changing market conditions|
• Can start off lower compared with fixed-rate mortgages but will likely increase after an introductory period
|Monthly Payment||• Monthly payment is predictable|
• Total amount of interest you will pay remains the same
|• Monthly payment can vary with changing interest rates|
• Total amount of interest you will pay can increase or decrease
|Amortization||• Amortization schedule is laid out for the entire loan term|
• You know the monthly payment amount and how much of each payment goes toward principal and interest
|• Amortization schedule subject to change as interest rates fluctuate|
• You won’t always know the monthly payment in advance or how much you’ll pay in interest
If you change your mind after committing to a fixed-rate mortgage or an ARM, you can decide to refinance your mortgage. However, you’ll need to qualify for refinancing, and it will come with additional closing costs, so weigh your decision carefully.
What Is a Fixed-Rate Mortgage?
With a fixed-rate mortgage, your interest rate gets locked in based on market conditions when you take out the loan, as well as your credit score, down payment, and other factors. A fixed interest rate remains the same for the life of the loan. As a result, you know from the start how much you’ll need to pay each month, and how much of each payment goes toward paying interest versus paying down the principal.
Fixed-rate mortgages are more popular with homeowners. In fact, according to the Consumer Financial Protection Bureau, 70% to 75% of homebuyers have historically chosen a fixed-rate mortgage. This interest rate type offers stability and predictability, so borrowers don’t have to worry about rate hikes causing their monthly payment to jump.
At the same time, the borrower’s monthly payment could still increase if the cost of their homeowners insurance or their property taxes change.
How does a fixed-rate mortgage work?
When you start making payments on a fixed-rate mortgage, most of it will go toward paying interest. Over time, more of the payment amount will be allocated to paying off the principal. Because your interest rate is fixed, your payments will generally stay the same each month, despite the varying distributions between interest and principal.
Fixed-rate mortgages often come with higher interest rates than ARMs — but only in the beginning. After an introductory period, the rate on an ARM may change while a fixed-rate mortgage remains steady. The only way your interest rate on a fixed-rate mortgage will change is if you refinance, in which case your rate will reset based on current market conditions and other factors.
15-year vs. 30-year mortgage rates
The interest rate you’re offered on a fixed-rate mortgage is affected by your loan term. Fixed-rate mortgages typically come with 30-year or 15-year loan terms, though some lenders will let you pick a custom term.
Generally, 30-year terms have lower monthly payments but higher interest rates and a greater total cost for the loan. With a 15-year term, you can score a better interest rate, which translates into a lower total cost. However, 15-year terms are often attached to bigger monthly payments.
According to Freddie Mac, as of Sept. 30, the average interest rate on a 30-year, fixed-rate mortgage in the U.S. is 3.01%, while the average interest rate on a 15-year, fixed-rate mortgage is 2.28%.
Fixed-rate mortgage pros and cons
A fixed-rate mortgage may seem like a safe bet, but it also comes with drawbacks. Here are some pros and cons to consider before making a decision.
Fixed-rate mortgage advantages
Getting a fixed-rate mortgage can be the right move for several reasons. Here are some of the upsides:
- Your monthly payment is predictable, which means you can plan more accurately for the future.
- The interest rate on your mortgage stays the same, so the total cost for the loan is set.
- You take on less overall risk with a fixed-rate mortgage.
Fixed-rate mortgage disadvantages
These are a few of the downsides to a fixed-rate mortgage:
- You’re usually charged a higher interest rate compared with the introductory period of an ARM.
- When you take out a mortgage while interest rates are high, you’ll be locked into that rate even if they drop later.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage is a home loan where the interest rate can vary, or adjust, throughout the loan term. The rate on an ARM is typically fixed for a certain number of years at the beginning, but it can increase after that initial period.
While some ARMs limit how high or low your interest rate may go, the tricky part is you can’t fully predict if and how the rate will change. It’s true that your interest rate could eventually drop, but that’s a gamble. Your monthly payment and total interest charged can also increase significantly, meaning ARMs are a riskier choice.
ARMs marketed to homebuyers who have lower credit scores tend to include higher interest rates, rates that adjust more often, prepayment penalties, and other riskier features. So, be sure to read the fine print and understand your mortgage options.
How does an ARM work?
Most ARMs come with a 30-year loan term. The interest rate typically starts lower compared with a fixed-rate mortgage and remains steady for an introductory period. The length of this initial period depends on the mortgage but usually spans three, five, seven, or 10 years. Some ARMs don’t offer an initial fixed-rate period, so make sure you understand how soon your monthly payment could change.
Once the introductory period is over, your interest rate will adjust and likely increase, which in turn will make your monthly payments more expensive. Your interest rate can continue to change every so often at a rate known as the adjustment period. The most common adjustment period is one year, which means you’ll get a new interest rate every year following the fixed period.
Using an example, a 5/1 ARM indicates that the initial interest rate will last five years, and the rate will adjust once every year after that until the mortgage is paid off.
According to Freddie Mac, as of Sept. 30, the average interest rate on a 5/1 ARM is 2.48%. For comparison, the average interest rate one year prior was 2.90%, and it was 3.38% during the same period in 2019 — showing that your initial interest rate could change significantly.
What causes your rate to adjust?
Your interest rate is composed of the index and the margin. The index is a measure of wider market rates and reflects overall trends in the economy. Lenders may differ in which index they use. The margin is an additional percentage that your lender tacks onto the index.
If the index changes after your introductory period, then your interest rate and monthly payment will change as well. Some ARMs set limits on much your rate can adjust. Here are three types of rate caps:
- An initial adjustment cap limits how much your interest rate can increase the first time it adjusts following the introductory period. This cap is commonly 2 percentage points or 5 percentage points.
- A subsequent adjustment cap limits how much your interest rate can increase after the first adjustment. This cap is typically 2 percentage points.
- A lifetime adjustment cap limits how much your interest rate can increase overall. This cap is usually 5 percentage points higher than the initial interest rate.
Your monthly payment could decrease if interest rates decline, but that doesn’t always happen. Lenders can also limit how low your rate may go.
Adjustable-rate mortgage pros and cons
ARMs may seem complicated, so here’s a breakdown of the advantages and disadvantages to choosing this interest rate type.
These are some of the perks of having an adjustable-rate mortgage:
- You may start off with a lower interest rate compared with fixed-rate mortgages.
- Depending on the market, your interest rate and monthly payment could decrease down the line.
- An ARM can be cheaper in the short term, especially if you plan to move again soon.
Adjustable-rate mortgages come with several drawbacks. Here’s what you need to consider:
- Less predictability makes it more difficult to plan for your other financial goals.
- If the interest rate on your ARM increases, you risk not being able to afford the higher monthly payments — and losing your home to foreclosure.
- Your rate and monthly payment may increase significantly. In fact, your interest rate can grow by as much as 5 percentage points or more compared with your initial rate.
Fixed or Adjustable-Rate Mortgage: Which Is Better?
There are many factors that can help determine what type of interest rate is best for you — including your financial situation, the initial rate, and how long you plan to say in the home.
“A fixed-rate mortgage is best for long-term stability,” says Tabitha Mazzara, director of operations at MBANC in Manhattan Beach, California. “Your monthly payment and interest rate stay the same, and they make budgeting easier.”
While ARMs can offer short-term savings, Mazzara warns of potential trouble down the line.
“ARM is not the best choice if you’re buying your ‘forever home’ because your rate might go up and strain your budget,” she says. “But it might make sense if the purchase is not for the long haul.”
When would it be better to use a fixed-rate mortgage?
Fixed-rate mortgages may appeal to borrowers who want to play it safe and are satisfied with their interest rate. You should consider a fixed-rate mortgage if the following statements apply:
- You want predictable payments and a lower-risk mortgage. Borrowers with a fixed-rate mortgage won’t face spikes in their interest rate, and have a clear sense about the full cost of their loan.
- You’re planning to stay put. If you’re keeping your home for the long haul, a fixed-rate mortgage is more suitable than an ARM. It also provides greater stability for making plans.
- Interest rates are low. A fixed-rate mortgage can help you lock in a favorable interest rate. This tool from the Consumer Financial Protection Bureau is updated twice per week and can show you typical interest rates in your area.
When would it be better to use an adjustable-rate mortgage?
An adjustable-rate mortgage may fit your situation if the following statements apply:
- You aren’t planning to live in the same place for long. If you’re going to sell the home before the interest rate adjusts, you could save money with an ARM. However, there’s no guarantee you’ll be able to sell or refinance before the introductory period ends. Also, if your financial situation has changed or your home’s value has dropped, you might not qualify for a refinance.
- Interest rates are high. With an ARM, your interest rate generally starts off lower compared with fixed-rate mortgages, and can decrease if market rates trend downward. With a fixed-rate mortgage, you would be stuck paying a higher rate for the rest of the loan term unless you refinance. Just be sure you can comfortably afford higher monthly payments if the interest rate on your ARM increases instead.
- You want to buy in a hot housing market. In recent months, ARMs have grown more popular among homebuyers in response to high home prices. However, all the risks associated with ARMs still apply.
The Bottom Line on Fixed-Rate Mortgages vs. ARMs
The biggest overall difference when you’re choosing between variable vs. fixed-rate mortgages is how much risk you’re willing to take on. Fixed-rate mortgages are safer, offering the full picture of how much your mortgage is going to cost. ARMs can help you snag a lower interest rate in the beginning, but you may end up with higher monthly payments and a greater total cost down the road. Before you make a final decision, be sure to weigh the benefits and drawbacks of each interest type.