Adjustable vs. Fixed Rate Mortgages

The choice of a home mortgage loan is just as important a decision as what type of home you choose and what type of neighborhood you want to live in. A mortgage loan is a long term commitment, and getting a great deal on your mortgage can help transform the roof over your head into a great investment. The two most common forms of home mortgage loan are the fixed rate loan and the variable or adjustable rate mortgage. This article will discuss the pros and cons of both approaches.

The first type of mortgage we will discuss is the fixed rate mortgage loan. A fixed rate loan is just what the name implies – a mortgage loan with fixed payments, and a fixed interest rate for the entire life of the loan. A fixed rate mortgage means that your last mortgage payment will be the same amount as your first mortgage payment. Many home buyers like the peace of mind and stability that a fixed rate mortgage can provide. Having a stable monthly mortgage expense certainly makes household budgeting and tax planning a lot easier.

The downside of the fixed rate mortgage is that it tends to come with a higher interest rate. This is because the bank or mortgage lender is taking all the interest rate risk. If interest rates rise substantially, suddenly your mortgage loan does not look so attractive to the bank. However, they are still committed to this long term loan, even though they are getting less than a market interest rate. Thus, banks and mortgage lenders make you pay for their assumption of risk through a higher interest rate.

The standard term for a fixed rate mortgage is 30 years, but loan terms of 15 years are also available, and are becoming increasingly popular. For those who can afford the increased monthly payments, a 15 year fixed rate mortgage can be a great deal. Not only is your home paid off in half the time, but you will end up paying a lot less interest on a 15 year mortgage loan compared to a 30 year loan. And despite what you may think, the mortgage payments will not double on a 15 year loan versus a 30 year. This has to do with the amortization schedule and the compounding of interest. So before you write off a 15 year mortgage as an impossibility, at least take the time to run the numbers – you may be pleasantly surprised.

Unlike fixed rate mortgages, adjustable rate mortgages have interest rates that will vary along with the overall interest rate environment. This means that holders of adjustable rate mortgages can profit from falling interest rates. When interest rates fall, the monthly mortgage payment will fall as well. Of course this also means that when interest rates rise your monthly mortgage payment will rise as well, so it is important to make sure your budget can handle any increase in rates.

Adjustable rate mortgages will have a cap above which interest rates cannot rise. It is vital for the potential borrower to run the numbers and determine his or her monthly mortgage payments in the event that rate rise to the highest level possible under the terms of the loan. If you are uncomfortable with the monthly payment under this scenario, an adjustable rate mortgage may not be right for you.

Remember that with fixed rate mortgages, the bank is taking the interest rate risk. Well with adjustable rate mortgages, that interest rate risk is shifted entirely to the borrower. Banks compensate mortgage borrowers for the assumption of that risk through lower interest rates. It is up to each individual borrower to determine whether the benefit is worth the risk.