What’s the difference between a fixed-rate mortgage and an adjustable-rate mortgage, or ARM? Which is better? Which one should I get?
Here, we will compare fixed-rate and adjustable-rate mortgages (ARMs) and discuss the meanings of other mortgage types: FHA, VA, and jumbo mortgages. We’ll also compare the two most common ways homeowners access home equity credit: home equity loans and home equity lines of credit (HELOCs).
Choosing the right mortgage is a savvy decision that could save you tens of thousands of dollars over the loan’s lifetime.
What is a mortgage?
A mortgage is a type of secured loan from an authorized credit provider, such as a bank or other financial institution. A borrower applies for a mortgage to buy or refinance a property, which serves as collateral for the mortgage. If the borrower defaults on the loan, the lender has the right to sell the property to the money back.
A fixed-rate mortgage has a set interest rate for as long as the borrower owes money on the principal. Even when the market index fluctuates, you will make the same payment each month. While the amount you pay towards the principal and interest will vary, the consistent amount makes budgeting simple.
A fixed-rate mortgage protects homeowners from sudden fluctuations in the market. Interest rates may spike due to a bull market, but you will be able to rest assured, knowing your monthly mortgage payment will remain unchanged. This easy-to-understand mortgage is a staple among mortgage lenders.
Most lenders offer 15-year, 20-year, and 30-year fixed-rate mortgages. The interest that you as a borrower would pay will depend on several factors, including your income, debts, and credit history. Many people opt for the 30-year mortgage because it has the lowest monthly payment. However, the 30-year loan also costs the most because of the accumulated interest of time.
Key features of fixed-rate mortgages:
- Straightforward budgeting
- Uniform payment amounts
- Protection against economic fluctuations
- Higher interest rates than ARMs
Adjustable-rate mortgage (ARM)
Adjustable-rate mortgages charge a variable rate. The amount that borrowers pay each month depends on the current interest rate. Lenders usually set the ARM rate slightly below the current market rate for fixed-rate mortgages.
Many homeowners opt for an ARM when interest rates are low. For instance, the Federal Reserve cut the federal funds rate to near zero in 2008 and 2020 in the wake of the economic recessions. If you were fortunate enough to acquire or refinance your mortgage at those times, you would have received a record-low interest rate.
The drawback is that interest rates go up and down with time. Even if a borrower can capitalize on a short-term lull in the market rate, that initial fixed-rate period will not last forever. Homeowners will likely have higher-than-average mortgage payments toward the end of the loan.
The fluctuation in interest rates makes ARMs more desirable for short-term loans. You should consider an ARM if you don’t plan to live in the house long enough for the interest rates to increase significantly or if you can pay off the balance within a few years. As a point of reference, the initial fixed-rate period usually lasts between one month and ten years.
If you want a predictable and easy-to-understand mortgage, ARMs probably aren’t for you. Not only do they have variable rates, but they come with a smattering of technical terms. Here is some of the terminology you’ll need to understand when evaluating ARMs:
- Adjustment Frequency – how often a lender adjusts the interest rate
- Adjustment Indexes – the benchmark lenders use to determine interest rates
- Margin – the difference between the adjustment index and your mortgage rate
- Caps – the limit for how much an interest rate can increase during an adjustment period
- Ceiling – the maximum interest rate you pay during the loan
ARMs can save borrowers a couple of hundred dollars per month for the first few years. However, once the new rate kicks in, homeowners are less likely to pay below the market rate. These variable mortgages have fallen out of favor following the Great Recession, causing government regulators to step in and oversee mortgage practices.
Key features of Adjustable Rate Mortgages (ARMs):
- Lower interest rates than a fixed-rate mortgage
- Possibly higher monthly mortgage payments
- Ideal for short-term homeowners
A Federal Housing Administration (FHA) loan is a government-backed mortgage for low-income homeowners. The Federal Housing Administration issues and insures the mortgages for qualified borrowers. People with a credit score between 500 and 579 must make a 10% down payment, while individuals with stronger credit can secure a reduced 3.5% down payment.
FHA loans are a go-to option for first-time homebuyers. You can borrow up to 96.5% of your home’s value, making it easy to put a roof over your head without straining your bank account. The modest down payment means that you can readily withdraw it from your savings or a down-payment assistance grant.
The FHA doesn’t provide borrowers the money for the mortgage. Instead, homeowners must go through an FHA-approved lender, like a bank or credit union. The FHA does insure and guarantee the loan, however.
In addition to the traditional mortgage, some versions of the FHA loan include:
- Home Equity Conversion Mortgage – a program for seniors that lets them convert home equity into cash while retaining the title
- 203(k) Mortgage Program – a loan that allows homeowners to borrow money for home improvements and repairs
- Energy-Efficient Mortgage Program – a loan that provides cash for energy-efficient home upgrades that lower operating costs
- Section 245(a) Loan – a program designed for borrowers who anticipate income increases. It starts with low initial monthly payments that get higher with time.
FHA loans have provided affordable mortgages to Americans since the 1930s. Congress created the FHA during the Great Depression when only 40% of people owned their homes. The federally insured loans reduced risk on behalf of lenders, and today, homeownership rates are at nearly 70%.
Homeowners who opt for FHA loans must pay mortgage insurance premiums (MIPs). MIPs come in two varieties, upfront and annual, and borrowers must pay these premiums each month, usually wrapped in with the other payments. An upfront MIP costs roughly 1.75% of the base loan, while an annual MIP costs 0.45% to 1.05%.
Key features of FHA loans:
- Ideal loan for low-to-moderate-income borrowers
- Lower down-payment requirement than conventional mortgages
- Mortgage insurance requirement
VA loans are mortgage loans from the U.S. Department of Veterans Affairs, establishing the loan’s standards and terms. While it does not provide financing, borrowers can secure the loan through a local VA-approved lender.
VA loans provide housing for active military, veterans, and their spouses. These loans come with favorable terms, making it easy to qualify, even if the homeowner has poor credit. The VA-approved lender provides up to 100% of the financing, including money to build and repair the property.
The 0% down payment is the most attractive feature of the VA loan, but not the only one. Borrowers also do not have to pay private mortgage insurance or a prepayment penalty. VA loans tend to have low closing costs, with some sellers paying for them on behalf of the homeowner.
Veterans and their families can take advantage of several VA loan varieties. For instance, the cash-out refinance enables mortgage holders to pay off existing debts, while interest rate reduction refinance loans (IRRRLs) help people get lower interest rates when they refinance.
The Native American Direct Loan (NADL) assists Native Americans in buying, building, and upgrading homes on federal land. Advantages of the NADL include no down payment requirements and relatively low interest rates.
Veterans can apply for the NADL through the U.S. Department of Veterans Affairs.
Key features of VA loans:
- Loan available to active military and veterans
- No down payment or mortgage insurance required
- Low closing costs
The risks of zero-down mortgages
While there are several benefits to VA loans, it is worth considering some of the risks and drawbacks to putting 0% down.
When you take out a zero-down mortgage, you have a higher amount to finance, which increases the interest you have to pay over time. If there is a downturn in property value, your debt will exceed your property’s worth.
Lenders generally perceive zero-down mortgages to be higher risk, and they’ll likely charge a higher interest rate on your loan.
Another drawback of zero-down mortgages is that you have no equity build-up. In other words, you will not be eligible for a home equity loan or HELOC to help you pay for emergency repairs or other unforeseen expenses.
Let’s say you have your eyes set on a half-a-million-dollar home, but the only problem is that you don’t have enough money in your bank account. You should consider a jumbo mortgage, which exceeds the limits set forth by the Federal Housing Finance Agency (FHFA).
Jumbo mortgage values vary from county to county. The FHFA sets annual conforming loan limit sizes for each area, and every mortgage that exceeds these limits is considered a jumbo mortgage.
Jumbo mortgages are not available through Fannie Mae or Freddie Mac, the government-sponsored enterprises that buy, guarantee, and securitize mortgages. Instead, borrowers go through private lenders to secure their loans. The loans have rigorous requirements, which have only become stricter following the Great Recession.
Borrowers should have a credit score of at least 700 before applying for a jumbo mortgage. You should also have a low debt-to-income ratio and a considerable amount of cash on hand for the down payment. Lenders typically ask for two years of pay stubs and W2s to verify income.
During recent years, the gap between the interest rates of conventional and jumbo loans has been closing. Today, jumbo loan interest rates are generally higher, but depends on your loan type, credit score, the loan term, and the loan-to-value ratio.
One of the key differences is the down payment. People should expect to pay 30% of the balance as a down payment as opposed to the traditional 20%.
Key features of jumbo loans:
- Loan amount exceeds limits of FHFA
- Loan has strict credit requirements
- APR is equivalent to conventional mortgages
Loan is through private lenders rather than through government-sponsored Fannie Mae or Freddie Mac
Home equity loan
A home equity loan is a type of consumer debt that allows homeowners to borrow against their property equity. The loan amount varies depending on the house’s current value and current first-mortgage balance.
Home equity loans are ideal for addressing immediate and sizable expenses. That might include consolidating debts, paying for college, starting a company, or going on a honeymoon. You can also deduct the interest on the home equity loan if you use it to buy, build, or upgrade your house.
Home equity loans have repayment terms that depend on your credit score and equity. You must make fixed payments each month that covers the principal and interest. The loans provide you with a valuable tool to get more value from your property.
You may find a lot of reasons to choose a home equity loan. They offer an easy source of income, low interest rates, and possible tax savings. The caveat is that home equity loans use your house as collateral.
A home equity loan is a property lien
A home equity loan is a property lien that grants the lender a legal claim on the property if the borrower doesn’t pay the debt.
Every time someone takes out a home equity loan, they are putting their house at risk. Most of the time, it’s a small risk. As long as borrowers can make the payments each month, they don’t have to worry about losing their homes. However, these loans can become a slippery slope that increases the chances of bankruptcy and foreclosure.
Key features of home equity loans:
- Fixed-interest rate
- Lump-sum payment
- Loan amount up to 85% of home equity
- Optimal method for consolidating debt or paying large bills
- Secured form of debt
Home equity line of credit (HELOC)
HELOCs share several similarities with home equity loans. Borrowers can withdraw money to cover immediate expenses and repay their debt with interest. They can also receive a tax break for using the money to upgrade their home.
While borrowers receive the payment from their home equity loan in a lump sum, HELOCs function more like credit cards. They come in two distinct phases: a draw period and a repayment period. The draw period involves using the home equity to pay for essential expenses, like medical bills and college tuition.
The draw period usually lasts ten years. Borrowers only have to pay the interest during this time. Once the draw period ends, they enter the repayment period, when they must repay the balance plus interest over 20 or so years.
The upside is that you can take out as much or as little as you need. HELOCs also tend to have lower interest rates than personal loans. According to Bankrate, the average HELOC has an interest rate of 2.99% to 21%, while personal loans range from 3% to 36%.
Homeowners who take out HELOCs should exercise discipline when using their home equity. The worst thing someone can do is use it for frivolous expenses. Borrowers will have to repay a more significant loan with more accumulated interest when the draw period ends.
Key features of HELOCs:
- Line of credit similar to a credit card
- Secured form of debt
- Adjustable interest rates
- Loans of up to 85% of home equity
- Loan suitable for short-term needs
Selecting the right mortgage
The right mortgage depends on your unique situation. If you plan on staying in one place for the rest of your life, opt for a fixed-rate mortgage. On the other hand, if you intend to refinance within ten years, apply for an adjustable-rate mortgage.
Federal Housing Administration (FHA) loans or VA loans offer unique advantages to borrowers, including low down payment requirements. If you qualify, consider applying for one of these loans.