Fixed Rate Mortgage vs. Variable Rate Mortgage

A fixed rate mortgage, as the term suggests, essentially “locks in” your interest rate for the life of the loan. Fixed rates tend to start off a little higher than adjustable rates but have the advantage of predictability. Barring minor adjustments due to insurance costs or balancing out your escrow account, they allow you to budget for a monthly fixed rate mortgage payment until your loan is paid in full.

A variable or adjustable interest rate mortgage, sometimes referred to as an ARM mortgage, is less predictable. The average market rates used to calculate what lenders will offer change constantly, although most mortgages are structured to avoid subjecting the borrower to quite that much chaos. The most typical structure is the 5/1 ARM, meaning your rate stays the same for the first five years and is subject to adjustment annually each year after that.

With ARM, your house payment can change over time and may go up considerably long before you’re close to paying off your loan. There are also forms of variable rate mortgages in which your payment stays the same but the percentage going towards interest varies along the way, possibly impacting the length of time it takes to pay off your loan rather than the payment amounts themselves.

Variable rate mortgages remain popular, however, for two reasons. First, most lenders start them off at below market rates, meaning they’re cheaper to begin with than a fixed rate loan. This is very appealing for homebuyers who may just be starting out, or who find their resources strapped by the other costs associated with buying a home and moving into it. Second, adjustable interest mortgages have historically proven to be a better deal than fixed rate mortgages. In other words, buyers have ended up paying less on average when taking their chances on an evolving interest rate. That in no way guarantees the same will be true going forward, but it certainly makes the possibility appealing.

An adjustable rate mortgage can also be desirable for borrowers who don’t plan on staying in the home long-term. If you’re buying with the intention of selling again in five years, for example, the lower monthly payments available with ARM may be ideal.

Defining Features

The home mortgage process comes with its own bewildering lexicon of issues and terminology. You should never feel foolish for not knowing all of them already, but you may find it helpful to familiarize yourself with a few as you begin to navigate the process.

Mortgage: Any real estate loan that comes with a specific schedule for repayment and uses the property being purchased as collateral. They generally require a down payment of 3% - 20% and monthly payments which combine interest and principle.

Collateral: Property used to guarantee a loan. If payments are not made, the lender has the right to take control of the property. Because of this, lenders sometimes require insurance or other guarantees of value on the property. They also avoid situations in which the amount owed is higher than the property’s current value.

Amortization: The schedule by which a loan is paid off. Borrowers are typically provided with an “amortization schedule” showing how much of each payment applies towards interest and how much towards principle. Typically, initial payments are mostly interest with the amount going towards principle rising gradually over time.

Interest: The cost of borrowing money, computed as a percentage of the amount borrowed. The bulk of any loan amount is the principle plus interest.

Principle: The amount actually borrowed still remaining to be paid.

Underwriting: Paperwork behind the lending process. Lenders use underwriters to verify your income, assets, and existing debt, and assess the likelihood you’ll be willing and able to repay a loan amount. Underwriters also order appraisals of the property, pull credit reports, etc.

Points: Fees paid to a lender at closing in exchange for a reduced interest rate on the loan (sometimes called “buying down the rate”). The longer you’re likely to own the home, the more paying points up front will save you over time. On a fixed home loan this will lower your monthly payments for the entire length of the loan.

Down Payment: Lump sum paid up front to reduce the amount being borrowed on a home or other major purchase.