If you have ever been in the market for a sizable loan, you likely have heard about loans being categorized as “fixed” or “adjustable.” While the consensus suggests that fixed interest rates are the way to go over the lifetime of a loan, the option for adjustable rates is still prevalent and supported by some financial experts.
It is important to understand what the differences are and why the debate rages on.
What’s The Difference?
Adjustable rates (frequently referred to as ARMs – Adjustable Rate Mortgages — when discussed in the context of home loans) involve the loan being reevaluated after a specified time and subsequently undergoing an adjustment to the interest rate, and consequently, the mortgage as a whole.
Fixed rates, on the other hand, remain constant for the lifetime of the loan. Once you lock in your interest rate, it is ensured for however long your loan term is.
What Are The Downsides?
Many initially shy away from fixed-rate loans because they are deterred by the higher cost upfront. Because these rates do not fluctuate over the life of the loan, they are often cited higher than their adjustable peers.
Another potential downside to having a fixed rate is that if interest rates do decrease, you cannot cash in on this benefit.
Public interest lawyer, Associated Press contributor and financial guru Matt Lee explained, “If interest rates are on the decline, then it would be better to have a variable (adjustable) rate loan. As interest rates fall, so will the interest rate on your loan.”
He concluded, “Therefore, adjustable-rate mortgages are beneficial for a borrower in a decreasing interest rate environment, but when interest rates rise, then mortgage payments will rise sharply.”
Adjustable rate loans have some highly quoted negatives, the most frequent of which is the borrower not anticipating how much the adjustments can influence their financial situation.
Financial expert and NerdWallet contributor Steve Nicastro explained, “If interest rates move higher after the initial rate period, your payments would also increase. If you are not ready for it, this could lead to ‘payment shock’ and in the worst-case scenario, result in default.”
Because of the complexities, addendums and exceptions involved in adjustable rate loans, they can carry a significant risk – the loan amount could increase over time, instead of decreasing with each payment.
While not likely, it is possible. Here’s how: Most adjustable rates include caps/maxes on the loan at its initiation and caps on monthly payments. When these two circumstances are combined in an unfavorable environment, with adjustments coming in at a higher interest rate than the monthly cap allows, the balance on the total loan can move upward.
What Are The Appeals?
Not only is it typically easier to qualify for fixed-rate loans, but there is an inherent security in knowing that your interest rate and monthly payments will not change.
While the risks are prevalent and highly cited by more conservative financial advisors, adjustable rates definitely have their positives as well. For one, adjustable rate loans typically begin with lower interest rates. Because of this initially low interest rate, monthly payments at the beginning of the loan’s lifetime can also be significantly lower than their fixed-rate counterparts.
Additionally, there is always the probability that adjustable rates will adjust down.
Adjustable rates are particularly appealing to a certain customer: the temporary loan holder. If a homebuyer is not planning on keeping the property for an extended time, adjustable rate loans can be a frugal decision. If the turnaround time between buying and selling is within the initial adjustment period, snagging the lowest interest rate possible – even if it is adjustable – can be a smart choice.
Above all, it is important to understand that the decision between adjustable and fixed rates is a personal choice. There is no right or wrong decision, but there may be a more beneficial choice for your particular situation. Understanding the differences between the options and weighing these into the equation of your own personal financial situation and expectations for the future can help you determine which option fits your lifestyle better.