There are a number of options to choose from when looking for a loan to purchase or renovate a home. Two of the most popular loan types are fixed-rate loans and adjustable-rate loans. Fixed-rate loans have the same interest rate locked in for the life of the loan. Adjustable-rate loans lock in an introductory interest rate for the first few years and they can fluctuate depending on outside factors throughout the life of the loan.
So which one is right for you? Below are a few questions to consider when deciding:
1. Will you be able to afford a mortgage increase?
With an adjustable-rate loan, your interest rate will fluctuate, typically once a year. If you have the income to support those unpredictable changes, you could end up saving money on your loan if your interest rate drops. However, if your interest rate goes up, so will your monthly payment.
If paying more than you can afford doesn’t sound like something you’re willing or able to do, a fixed-rate loan might be the safer bet. Your monthly payments will not change due to fluctuating interest rates and you can easily budget for your monthly bill. With a fixed-rate loan, you will also have the option to refinance and lock in a lower interest rate if it’s available.
2. Do you want to have the option of refinancing?
The value of your home, your credit score, accumulating too much debt and losing some of your income can affect whether or not you are able to refinance an adjustable-rate loan.
If your home value drops too much or your credit score takes a hit before an interest rate adjustment period, you may be denied the ability to refinance for a lower interest rate, leaving you stuck paying a potentially high monthly bill. This inability to refinance adjustable-rate loans was part of the cause of the mortgage crisis of 2008-2009.
If you aren’t able to afford your mortgage payments increasing (sometimes doubling), then a fixed-rate loan might be a safer bet. No matter what happens to your credit score, income or home value, the interest rate of your loan will always remain the same.
Consider your other bills and loans that might affect your credit down the line. If not being able to refinance your loan is a concern, consider a fixed-rate loan.
3. Are you planning on staying in your house for more than 10 years?
If the answer is yes, a fixed-rate loan might be best since your payments will be consistent for the life of your loan.
If you’re not sure how long you’ll be in your home, or you know that you’ll be living in the home only temporarily (such is the case for many military families and families planning on moving into a larger home once they have children), an adjustable-rate loan might be more ideal.
Most adjustable-rate loans have lower introductory interest rates compared to fixed-rate loans. Knowing you’re only going to be paying this loan off for a few years means you don’t have to worry so much about fluctuating interest rates once your first interest rate adjustment period hits.
4. Do you want the option of paying off your mortgage in 5, 10, 15 or 20 years?
If you’re looking for more options and flexibility in terms of how long you’ll be paying off your mortgage, consider a fixed-rate loan. Fixed-rate loans are available in a variety of yearly terms and the shorter the term of your loan, the lower the interest rate will be. This means you’ll end up paying less in interest altogether and you will build equity and own your home sooner. But remember: The shorter the loan period is, the higher the monthly payments will be.
If you’re not so concerned with the length of your loan, an adjustable-rate mortgage might be right for you. Most adjustable-rate loans only come with 30-year terms with the interest rate fluctuating within those 30 years. However, your introductory interest rate will probably be lower than a fixed-rate loan.
5. How large of a down payment can you afford?
The more money you have for a down payment, the less money the mortgage company will need to loan you, which translates into less of a risk on the part of the lender. Oftentimes, you can get a lower interest rate with a larger down payment.
If you are in the position to get a low interest rate because you can offer a large down payment, locking in that interest rate with a fixed-rate mortgage could benefit you in the long run.
If you don’t have enough cash to offer a large down payment, a fixed-rate loan still might be a good choice. But keep in mind that you will probably have to pay PMI (private mortgage insurance) if your down payment is less than 20% of the loan total.
PMI adds to your total monthly payment and if you have PMI on an adjustable-rate loan, you could be paying even more after a few years if the fluctuating interest rate of your loan increases your monthly payments.
Talk to an expert when choosing between a fixed and adjustable rate loan
Taking out a loan is a big commitment and a huge step in many people’s lives. Take careful consideration of your finances, goals, investments, and lifestyle before committing to a certain loan, and be sure to seek out an experienced team of loan experts to help you weigh your options and find the right loan type for your needs.
Roger Odoardi, co-founder, partner and licensed mortgage broker at Blue Water Mortgage Corporation, an independent mortgage broker serving Massachusetts, New Hampshire, Maine, Connecticut, and Florida, has 20-plus years of experience in the financial services industry.