Fixed vs Adjustable Rates

Apples vs. oranges. Boxers vs. briefs. Dave Letterman vs. Jay Leno. These debates may rage on for decades, and we can add another one to the list: fixed vs. adjustable. We’re speaking, of course, of fixed rate and adjustable rate mortgages.

Let’s start the discussion by talking about risk. If I had to pick one word that explained the mortgage industry, it would be risk. If you can understand the concept of risk and how it relates to mortgages, you’re way ahead of the game. In a nutshell, riskier loans mean higher interest rates; you compensate the person lending you money by paying them a higher interest rate. If you have low FICO scores, this is a higher risk to the investor since you don’t have a good history of paying your bills on time, so you’re going to have to pay a higher rate. If you can’t verify enough income to qualify for the loan, this is a higher risk and you’re going to have to pay a higher interest rate.

As it relates to this discussion, the longer you ask the lender to guarantee your interest rate, the higher risk for them since they’re guaranteeing the rate you get but they don’t know how much their funds are going to cost them going forward. This isn’t an easy concept to wrap your mind around, so don’t feel bad if you don’t get it yet. Lenders work on a concept called arbitrage, which is a fancy way of saying they borrow money at a certain rate and then lend it out to you. However, lenders don’t get money at 30-year fixed rates, so when they borrow money they have to try to gauge what it’s going to cost them over the time they lend it to you. If you’re following me so far, you can understand why they would charge a higher rate to guarantee you a certain rate for 30 years as opposed to 3 or 5 years. Now, on to our discussion…

On the one hand, we have fixed rate advocates. These days, this is a relatively easy argument to make since rates are at 40-year lows. The main reason to get a fixed-rate mortgage, whether it be a 15-, 20-, or 30-year fixed, is to protect yourself from adjustable interest rates. When you get a fixed rate loan, you know exactly what your payments are going to be and they’re not going to change for the life of the loan. In a time when rates are rising, a fixed rate mortgage gives you the security of knowing that you’re safe.

On the other hand, there are the adjustable rate advocates. The main argument here, in a nutshell, is that you shouldn’t pay for something you don’t need. A great majority of people out there will only keep their mortgage for 3-5 years. Maybe it’s a job change, maybe it’s an expanding or contracting family, a refinance for home improvements or college for the kids, or any number of life circumstances. Since you’re probably not going to keep your mortgage for 15 or 30 years, you’re probably better off to get a lower adjustable rate mortgage and pocket the difference.

I’m not going to say one argument is better than the other. There’s no such thing as a “good” or “bad” loan, but there are loans that are better or worse for certain people. In my career as a mortgage consultant, I can tell you that I’ve done very few fixed rate loans. I only recommend them in two cases – when people are on a fixed income and need to know exactly what to expect from their mortgage, or when people are absolutely sure that they’re not going to move or need to refinance for many, many years. In a great majority of cases, people don’t need a fixed rate loan and would in fact be much better off with a loan that accomplishes their goals and saves them money in the long term. Like oranges vs. apples or Letterman vs. Leno, fixed vs. adjustable is not a debate that can be definitively settled, but I hope I’ve helped you figure out which one may be right for you.