Mortgages can be a complicated issue, made up of various components. The interest rate you’ll pay is one of the most important aspects of your mortgage because it has an impact on how much your payment will be each month. To further complicate matters, there are two quite different types of interest rates: fixed and variable. You get to choose which one you want, and this can come down to whether you’re the type who doesn’t mind and can afford rolling the dice a little with an interest rate that can fluctuate.
How Mortgage Loans Work
You’ve found the home of your dreams and you want to buy it, but you don’t happen to have $275,000 sitting there in a savings account, at your disposal. You’ll have to borrow that money – or at least a healthy chunk of it – from a mortgage lender.
You’ll have to qualify for a mortgage. The lender will want to know that advancing you all this money isn’t too much of a risk. You’ll enter into a contract for repayment and the lender will charge you interest on the amount you borrow for the life of the loan in exchange for the courtesy. This interest is payable each month, included in your monthly payment as you chip away at your borrowed principal balance. The contract gives the lender the right to seize or foreclose on your property if you - the borrower - fail to make payments and default on the loan.
Read More: The Pros & Cons of Mortgages
How Interest Rates Work
Both fixed and variable interest rates depend on the economy and the interest rate environment. Your lender won’t simply pull a number out of the air. It’s based on a measure of interest rates called an index that’s established periodically by governments. Interest rates rise when this index goes up. Likewise, they fall when it drops.
Read More: Credit Score for Mortgage Rates: How It Works
The most commonly used index rate is the one-month London Interbank Offered Rate, or LIBOR index. Banks charge this rate to each other when they loan and borrow between themselves. The “one-month” part means that the prevailing interest rate can go up or down each month, and this, of course, depends on a variety of economic factors. Your mortgage contract should tell you what index your lender is using to establish your rate.
Read More: How to Calculate Mortgage Interest
A word of warning: The FDIC cautions against taking out a variable-rate mortgage now with the thought that refinancing later can save you if interest rates go through the roof at some point in the future.
How Fixed-Rate Loans Work
An advantage in taking out a fixed-rate loan is that your interest rate will remain the same throughout the life of your mortgage, whether that’s 15 years, 20 years or 30. You'll pay in the area of the current rate at the time you take out your loan. The rate can skyrocket a month later, but that's not a problem – it won’t affect your budget because your rate won't hike along with the index. By the same token, the index might plunge a month later but you’ll still be stuck paying interest based on whatever it was at the time you purchased your home.
Nonetheless, this can be a very good situation if your budget or temperament need predictability. You don’t like surprises, and a fixed-rate mortgage will let you plan your budget years in advance if doing so lets you breathe easier. Your mortgage payment will always be the same each month for the loan term, or close to it when you account for other variables that can rise or fall, such as homeowners insurance and taxes. These costs of homeownership are often included in a mortgage payment as well.
Most unsecured loans charge a fixed interest rate, including auto loans and student loans. You know exactly what you’re getting into from the inception. Alliant indicates that a 30-year fixed-rate mortgage is more or less the industry standard.
Read More: How Does a Mortgage Work?
How Variable-Rate Loans Work
Variable-rate loans – sometimes referred to as adjustable-rate mortgages, ARMs or floating rate loans – take the opposite approach. Your monthly mortgage payment hinges on the prevailing interest rate at a particular time – but not necessarily immediately. These mortgage loans typically begin with a fixed interest rate for a period of time. There will be no fluctuations, at least not affecting your wallet, during this time. You’re guaranteed that your rate won’t go up or down for a matter of months or even years, but your interest rate will be subject to fluctuation after this time expires.
The terms of a variable rate loan read something like a grade school math lesson. They’re depicted as a fraction. For example, a 3/1 ARM means that your rate will remain the same for the first three years, and that it can adjust to the prevailing interest rate annually, or each single year, after that. A 5/1 ARM is the most common, but some lenders actually offer 10/1 variable rate loans.
These mortgages aren’t all created equal. Some lenders won’t reduce your interest rate if the index happens to drop below what you’re already paying. Some will obligingly place a cap on just how much your rate can increase regardless of how high the prevailing interest rate rises, but the increase can otherwise be quite significant and the cap doesn’t always apply to the first rate adjustment.
You’ll typically receive something in exchange for signing up for this kind of financial gamble. Variable-rate loans often offer lower interest rates at their inception than fixed-rate mortgages do. That period can last anywhere from one to 10 years before the seesaw effect kicks in.
Read More: What Is an Adjustable Rate Mortgage?
Things to Consider When You're Deciding
Choosing between one type of mortgage or the other is obviously a weighty decision for homebuyers. It will affect you for years to come. It’s largely based on your goals and your financial situation.
A fixed-rate mortgage might be best for you if you plan to live in your mortgaged home for an extended period of time, at least 10 years if not longer. There’s no telling what the economy will be like that far in the future, but it won’t matter because your interest rate is not going to change. You’re in this for the long haul, and you want the security of knowing that your interest rate isn’t going to behave like a bouncing ball during that time – particularly if rates are nicely low at the time you take out your mortgage. You might want to freeze that rate for the life of your loan.
A variable-rate loan might suit you best if you feel pretty confident that your income is going to increase over the coming years. You can take advantage of that low interest rate in the here-and-now if your budget is a little tighter than you expect it to be in five or 10 years – particularly if you think you might want to move on to another residence during that time. You can enjoy lower mortgage payments now than you would have with a fixed-rate mortgage until the time comes to move on.
Finally, a word of warning: The FDIC cautions against taking out a variable-rate mortgage now with the thought that refinancing later can save you if interest rates go through the roof at some point in the future. You don’t know how much your property might appreciate in that time, and a refinanced fixed-rate loan at high interest rates then could be somewhat comparable to what you’d be paying on your variable-rate mortgage.
Read More: Can You Refinance for 100% of the Home's Value?
Of course, you could always refinance your fixed-rate mortgage into a new fixed-rate mortgage to take advantage of interest rates that have plunged at some future point in time. But a second batch of closing costs might take at least a small bite out of any savings you realize.
Read More: Where To Start When Buying a House
- Consumer Financial Protection Bureau: What Is the Difference Between a Fixed Rate and Adjustable-Rate Mortgage (ARM) Loan?
- SoFi: Fixed vs. Variable Rate Loans
- Bankrate: Choosing Between an ARM Versus a Fixed-Rate Mortgage
- Alliant: 10/1 ARM vs. 30-Year Fixed – Which Mortgage Is Right for You?
- Charles Schwab: Fixed-Rate Mortgage vs. ARM – How Do They Compare?
- Consumer Financial Protection Bureau: What Is a Mortgage?
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.