Fixed Rate v. Adjustable Rate

A fixed rate loan is generally better than an adjustable rate loan if you are planning to stay in the home for more than 7 years and need your monthly payment of principal and interest to remain the same throughout the loan term for financial planning purposes or because you cannot afford substantially higher payments if there is a wide fluctuation in the interest rate.

Most adjustable rate loans have a predetermined period at the beginning of the loan term when the interest rate is fixed. The initial fixed rate period can be 1, 3, 5, 7 or 10 years. The initial interest rate on adjustable rate loan is usually lower than with a 30-year fixed rate loan by sometimes more than 1 percentage point depending on how long or short the initial fixed rate period is. The advantage of an adjustable rate loan is that your initial monthly payments of principal and interest will be less than with a 30-year fixed rate loan.

Most adjustable rate loans are structured so that when the initial fixed rate period ends, the first adjustment to the interest rate is capped at 5% and the annual adjustments thereafter are capped at 2% not to exceed the agreed upon maximum interest rate. If you took out a 5/1 adjustable rate mortgage at 3.250% with a 5/2/5 cap structure and there is wild fluctuation in the index rate during the initial 5 year fixed rate period, then your interest rate during the sixth year of the loan term could go up as high as 8.250%. This would greatly increase your monthly payment and if you can't afford that kind of volatility, then an adjustable rate mortgage may not be the right choice for you.

An adjustable rate loan may be the right choice for you if your financial circumstances necessitate a lower payment initially and you are willing to take the risk that your interest rate may in later years go up significantly. An adjustable rate loan may also be the right choice for you if you are planning on staying in the home for less than 7 years. However, if there is uncertainty as to your future plans then a fixed rate loan may be the less risky choice.