You are ready to apply for a mortgage. Your question? Should you take out a fixed-rate loan or an adjustable-rate?
As with most mortgage questions, there is no one right answer. The right loan for you depends upon a wide range of factors, everything from how low or high average mortgage rates are when you are ready to apply for a loan to your family's financial situation.
The best way to decide whether you should aim for a fixed-rate or adjustable-rate loan? Do the research.
Before you can decide whether a fixed-rate or adjustable-rate mortgage is right for you, you need to learn the fundamental differences between the two.
As the name suggests, the interest rate does not change with a fixed-rate mortgage over the term of the loan. No matter whether your loan extends for 30 years, 15 years or some other length of time, your interest rate will remain unchanged throughout the duration of the loan.
An adjustable-rate mortgage works oppositely. Your interest rate will change after a set number of years, often five or seven. Usually, the rate starts out lower for the first few years and then adjusts to a new rate based on a set of economic factors. The rate does not have to go higher after the adjustment period, but it usually does.
Benefits of a fixed-rate mortgage
Each loan type comes with its benefits. For fixed-rate mortgage loans, the advantage is an obvious one: There are no surprises with this kind of loan. You will know each month exactly what your mortgage payment will be. It will not rise or fall.
A fixed-rate mortgage loan is especially attractive when average mortgage interest rates are low. That has indeed been the case in over the last several years. Average interest rates on 30-year fixed-rate mortgage loans averaged about 3.69 percent in early January 2020. That is almost a single percentage point lower than the same time in 2019. Rates remain low from a historical basis.
This meant that fixed-rate loans currently make good economic sense for homeowners who want the lowest possible mortgage payment each month. Taking out an adjustable-rate loan in such a rate climate might be a risk. After all, when an adjustable-rate mortgage loan adjusts in five or seven years, there's no guarantee that interest rates will not be higher than they were in 2020.
Benefits of adjustable-rate mortgages
Adjustable-rate mortgage loans make the most sense when average mortgage interest rates are high. That is because lenders can usually provide borrowers with a lower initial interest rate because they can raise the rate at a later date if rates rise to a higher level during the mortgage term.
If rates are high, then, borrowers who take out an adjustable-rate mortgage loan will enjoy a lower interest rate for a set period, again, usually five to seven years. That can result in significantly lower monthly mortgage payments during this time.
However, there is a risk. After the adjustment period, your interest rate might jump by a fairly significant amount. Make sure before taking out an adjustable-rate mortgage that you can afford whatever the adjusted monthly payment would be. You might be able to factor future pay raises to help you make those higher payments if you believe that your income will grow over time.
Like all mortgage products, adjustable-rate and fixed-rate mortgage loans come with their pros and cons. Your best bet is to study both products carefully before making your choice.