Fixed Rate Mortgage or Adjustable Rate Mortgage: Which is Best for Your Needs?

Fixed rate mortgages and adjustable rate mortgages (ARMs) are the two main mortgage types. Each type of mortgage is vastly different and deciding on which type to obtain when buying a home will save money and avoid costly mistakes. 

There are many variations of each type of loan which can make decisions more difficult, especially for first time home buyers. Following are the main differences between fixed rate mortgages and adjustable rate mortgages.

Fixed Rate Mortgages

Fixed rate mortgages have a "fixed interest rate" that is set when you obtain the loan and doesn't change for the life of the loan. Having a fixed rate for the entire period makes your monthly mortgage payments of principal and interest predictable since it never varies. Although the monthly mortgage payment to the bank will be the same, your monthly payments can go up if your escrow payments increase.

Escrow payments are for the property taxes and property insurance. Most homeowners pay escrow payments within their mortgage payments. The lender takes the escrow payments and pays the property tax and property insurance.

With a fixed rate mortgage, both the monthly principal (the debt you owe) and interest is paid down each month. The actual amount of principal and interest you pay each month varies. For the first years, most of your monthly payment goes towards interest and less towards paying down principal. Over time the amount of money going towards interest goes down and the principal payment increases.

The main reason fixed rate mortgages are the most popular is that the interest rate is fixed and the monthly payment is the same. The mortgagee doesn't have to worry about fluctuation in interest rates, which can cause the monthly payments to increase.  The downside is that if interest rates decline, your rate will remain the same.

To give you an idea of how greatly interest rates can fluctuate, today's (4/14/11) average 30 year fixed mortgage rate is 4.94. In the early 1980's 30 year fixed rates were as high as 17.25%

Fixed rate mortgages are available in several different terms. The most popular terms are 30 years and 15 years. If you can afford a 15 year loan, you will get a lower interest rate than a 30 year loan. You will also own your home outright in half the time. The only downside is your monthly mortgage payments will be substantially higher.

Adjustable Rate Mortgages

With adjustable rate mortgages (ARMs), the interest rate is fixed for an initial period of time but after the initial period, the interest rate can adjust every year. The initial mortgage rate on adjustable mortgages is lower than fixed mortgage rates.

To give you an example, right now fixed 30 year rates are at 4.94% and 5 year adjustable mortgage rates are at 3.40%.

When the interest rate "adjusts" on your loan, your monthly mortgage payments can go higher or lower. Adjustable mortgages are at the mercy of the prevailing interest rate but can increase even if interest rates do not go up. There are usually yearly caps and lifetime caps on how much the interest rate can increase, which can help limit the pain.

Deciding on the Ideal Home Loan

The first step to buying a home is deciding on which type of loan best suits your needs. Which is best depends on your financial situation, the amount of time you plan to be in the home and your tolerance for risk.

You can have your mortgage lender guide you and help you figure out which loan is better for you but you first need to understand both types loans and how selecting the right (or wrong) one can affect you.