Understanding The Difference Between Adjustable and Fixed Rate Mortgages

At the most basic level, fixed rate and adjustable rate mortgages differ in the way that interest rates are calculated and how you pay off the loan. As the name implies, a mortgage with a fixed rate maintains the same interest rate for the entire term of the loan, and the amount you are required to pay per month typically remains static as well, although there are some exceptions made for lenders who specify an alternate payment structure at the outset of the loan.

Known in the industry as a "vanilla" loan because of their relative ease of understanding and use, fixed rate mortgages typically span a pay off period of either fifteen or thirty years. Mortgages with an adjustable rate may span the same number of years, but the interest rate is tied to a specific financial index that is used by lenders to monitor the general fluctuation in interest rates in the overall economy. Because the loan interest rate is affixed to the index, both your interest rate and monthly payment amounts will change based on the shifting interest rates in the U.S. economy.

Fixed Rate vs. Adjustable Rate Mortgages

Despite the appeal of the simplicity of a fixed rate, many people are initially drawn to adjustable rate mortgages by the promise of lower interest rates and monthly payments during the first year or two of the loan term. Besides the obvious appeal of a lower interest rate and monthly bill, the lower payments are often rather sneakily used by lenders to offer their clients a larger loan amount than they would normally qualify for, allowing borrowers to purchase a larger or more valuable home. Borrowers who opt for a mortgage with adjustable rates also win big if interest rates fall during their loan payment term, since their loan automatically adjusts to the lower rates without the hassle and stress of refinancing.

On the other hand, there is something to be said for the stability of having a fixed interest rate and monthly payment. While you may get lucky with an adjustable rate loan and falling interest rates, you’re just as likely to fall suffer the effects of having to adjust to higher rates, as the interest rates in the economy rise, and even if they remain relatively stable, those lowered introductory rates the lender used to lure you in with don’t last, and people who have borrowed beyond their recommended limit based on those lower payments may suddenly find themselves unable to handle their new monthly loan payment, resulting is financial hardship and in some cases, default. Fixed rate mortgages may not be as flexible as the adjustable rate loans, but you won’t face rising interest rates or monthly payments, no matter what happens to interest rates in the overall economy.

Some lending institutions offer hybrid mortgages, which allow borrowers to switch from a fixed interest rate to an adjustable, over a set period of time, or to choose month by month whether they prefer to make minimum payments, pay on the loan interest only, make their regularly scheduled payment amount, or pay more than is required. No matter what your preference, be sure to ask your lender for full disclosure of any potential fee additions or increases, and never commit to a loan without fully understanding what you’re getting into.