First-time homebuyers might spend as much time shopping for a mortgage as they do house hunting. Lenders can throw out unfamiliar terms, and if you want to make the best financial decisions, you’ll need to get up to speed on the many different types of mortgages. One key mortgage “ingredient,” the interest rate, plays a significant role when determining the price a buyer can afford to pay for a home. The specific interest rate that a homebuyer secures will affect their purchasing power, but they should also consider the kind of interest rate they acquire. Buyers can choose between adjustable-rate mortgages (ARM) and fixed-rate mortgages.
How do Interest Rates Affect Homebuyers?
Each month, homeowners will pay a mortgage payment that consists of two portions: an amount toward the original loan balance, called the principal, and some interest. Homebuyers can use a mortgage payment calculator to estimate their monthly payments. The higher the interest rate, the more homeowners must pay monthly. Homeowners may need to adjust their budgets to accommodate higher interest rates.
Changes in interest rates can result in real-time effects on real estate prices. In 2022, interest rates hit record-high levels, pricing buyers out of the market as they could not afford larger monthly payments. Throughout 2023, those buyers returned to the housing market when interest rates dropped. In addition to this effect on home prices, changes in interest rates may also affect the type of mortgage a buyer chooses.
What’s the meaning of ARM vs. Fixed Rate?
Interest rates impact your buying power and can vary between lenders and individual mortgage loans. For this reason, all borrowers should understand each mortgage lender’s ARM loan meaning vs. fixed-rate loans.
Adjustable Rate Mortgage Loans (ARMs)
An adjustable-rate mortgage offers the borrower an interest rate that fluctuates based on an underlying index or benchmark, such as the Federal Reserve’s prime rate. Generally, adjustable-rate mortgages begin with a lower introductory rate than similar fixed-rate loans. However, the interest rate for an ARM changes after a specified time, based on a stated current index rate at the reset date, plus an additional amount, known as a margin.
Lenders typically label ARM loans using two numbers, such as 5/1 or 7/1. The first number represents the introductory period or the years until the beginning interest rate resets. The second number represents the rate reset frequency after the initial period. For example, a 5/1 ARM would carry the same interest rate for the first five years and then reset every year, based on the underlying benchmark rate, for the remainder of the life of the loan.
ARMs carry more risk, as buyers cannot determine how far an interest rate will sway down the line. For this reason, they are less popular than standard fixed-rate mortgages. Adjustable rate mortgages comprised only about 10% of the mortgage market in 2022.
Interest Rate Caps for ARM Loans
Homebuyers looking into ARM loans should inquire about interest rate caps. These caps help to reduce risk by assuring the loan’s interest rate does not exceed a set amount. In addition to lender specifications, government regulations may dictate the highest allowable rate for mortgages. Borrowers considering an adjustable rate mortgage should ensure that the lender places a cap on the rate to avoid a spike in interest rates leading to an unaffordable payment.
Over the life of a long-term loan such as a mortgage, the changeable nature of adjustable interest rates creates a degree of uncertainty for the borrower. Although credit cards and other kinds of debt may also offer adjustable interest rates, the larger balance associated with a mortgage means that even a small change in interest can significantly affect monthly payments.
Fixed-Rate Mortgage Loans
A fixed-rate mortgage carries the same interest rate over the life of the loan. The payment will not change for a fixed-rate loan, eliminating the risk related to changes in interest rates. As a result, the predictable nature of a fixed-rate mortgage makes them popular for most homebuyers. Fixed-rate loans simplify budgeting and financial planning for homeowners because they don’t need to worry about shifting money around to cover higher mortgage payments. However, if interest rates decrease significantly, fixed-rate borrowers will not benefit unless they take steps to refinance their current loan.
Reasons to Consider an ARM
Even with the additional interest rate risk, an ARM could make sense for a particular homebuyer under certain conditions. Some situations where you may consider looking into an adjustable-rate mortgage include the following:
You Plan on Moving in the Near Future
If you buy a home with the intention of moving again when you start a family or relocate for a job, an ARM could make sense. The adjustable rate’s lower introductory rate could compare favorably to a fixed-rate mortgage loan. By paying lower interest rates during the introductory period, a homeowner could plan to save the additional funds in their budget for a larger down payment on their next home purchase. By the time the introductory period expires and interest rates rise, the homeowner might have already sold the property, paid off the ARM, and moved on, thus avoiding the need to pay the higher, adjustable rate.<
Interest Rates Rise
ARM loans rise in popularity when interest rates rise, as they provide a lower alternative to fixed rates in the first few years of the loan. The borrower could accept a lower introductory rate and anticipate that the high current rates will drop by when the loan resets. Or, the borrower could plan to terminate the loan and refinance or buy a new home before rates reset. For example, borrowers who selected an ARM throughout 2022 may benefit from a lower rate if rates fall by the time their introductory period expires.
Each borrower must consider current interest rates, which type of mortgage loan the lender offers them, and their relative confidence in future interest rate movement. If a buyer accepts the additional risk of an ARM and rates do not move as predicted, they must plan to cover the higher monthly payments until they can refinance or obtain a new mortgage loan.
Lower Qualification Requirements
First-time buyers lacking a supportive credit history or those who don’t qualify for the lowest interest rates may choose an adjustable-rate mortgage due to its lower introductory rate compared to a fixed-rate loan. The borrower will have time to pay down their debt, improving their credit rating. This could help them qualify for a future refinance or a new loan with a lower, fixed interest rate.
Prospective buyers who aim to purchase a property as soon as possible but do not yet meet conventional loan requirements may opt for an ARM to ensure they meet their homeownership goals.
Reasons to Consider a Fixed-Rate Mortgage
Borrowers looking for stable, predictable monthly payments tend to gravitate toward fixed-rate loans. For first-time borrowers, fixed-rate mortgages may seem easier to grasp and can help them stay on track through the early years of homeownership. Although borrowers risk losing the chance to lower their payments if rates decrease, avoiding the risk of a higher payment can entice them to choose this type of loan. If interest rates do drop, fixed-rate borrowers can refinance to lower their monthly mortgage payments. They will pay some fees to refinance but can still benefit from restructuring a loan if rates drop significantly.
Homebuyers may select a fixed-rate loan due to the following reasons:
Interest Rate Stability
When interest rates approach historic lows, similar to rates seen during the recent COVID-19 pandemic, borrowers will prefer a fixed-rate mortgage. Despite recent increases, interest rates remain below historic highs, making fixed-rate loans affordable for many homebuyers. Due to the inherent stability of a fixed-rate loan, risk-averse borrowers continue to rely on this type of mortgage during periods of economic uncertainty. They may even push up their buying timeline to secure a favorable rate on a fixed loan. If current interest rates slowly increase, homebuyers may feel pressured to lock in a fixed rate before they become priced out of the market.
Easier to Budget
A fixed-rate loan makes budgeting and financial planning easier. Your monthly housing payment may comprise a significant portion of your spending budget, which means you will want to limit the risk of this amount increasing as much as possible. While you may accept adjustable rates for a credit card or smaller loan, you may find it more difficult to deal with a large change to your mortgage payment. If your mortgage amount remains the same, you can easily determine how much income you’ll have left to cover other items, such as home renovations, vacations, or college tuition for your kids.
Understand the Effect of Interest Before Choosing a Mortgage Loan
Before you decide on a fixed-rate mortgage vs. an ARM, take the time to understand how interest rates affect your payments. Although the popularity of adjustable-rate mortgages shifts along with changes in interest rates, more buyers prefer the stability of fixed rates.
Each lender must prepare a truth-in-lending disclosure to document the terms of the loan they offer. If you’re considering an ARM, pay special attention to the interest amounts in the disclosure. Ask the lender to talk you through the information to help you understand the terms of your loan. The lender must report the maximum interest you could pay if your interest resets to a higher rate.
Even if you believe interest rates will drop in the future or you plan to sell the home before the rate resets, life is unpredictable. Ask yourself if you could pay a higher amount of interest if needed. Before you select an ARM, compare the total interest for a similar-term, fixed-rate loan. Based on your personal risk tolerance, you may want to pay a slightly higher fixed rate rather than accept the chance you may need to pay the maximum rate of the adjustable rate mortgage. If you stay with a fixed-rate loan, you can also take other steps to lower your interest rate, such as paying points upfront.
