If you’re in the market for a home loan this year, one of your first decisions will be choosing what kind of loan to take out.
The most common types of mortgage loans are adjustable-rate mortgage (ARM) and fixed-rate mortgage loans. Each of these has their own unique advantages, so the key is to choose the best home loan option for your particular situation. Let’s break it down.
Fixed-Rate Mortgage Loans
In a nutshell: long-term predictability
As its name suggests, a fixed-rate mortgage (FRM) has an interest rate that stays the same for the entire life or “term” of the loan, even if it’s 30 years. The rate remains fixed regardless of any fluctuations that might occur in the broader economy.
You can probably already see the primary benefit of this type of home loan. Fixed-rate mortgage loans offer greater stability and predictability over the long term when compared to their adjustable counterparts.
By its nature, a fixed-rate loan shields you from higher interest costs down the road. Long-term interest rates tend to rise during periods of economic growth, so the cost of borrowing can rise as well. But with an FRM, you can lock in a mortgage rate and preserve it for the life of the loan—even if lending rates rise significantly during that period.
That’s the upside. The downside is that, generally speaking, fixed-rate home loans have higher interest rates than adjustable-rate mortgages. It’s the price you pay for stability and predictability. Of course, the rate you receive from a lender will depend on several variables, including personal factors like your credit score. But rates are also influenced by the type of loan you choose.
For some borrowers, the advantages offered by the FRM outweigh the potentially higher interest charges. This is especially true for home buyers who are planning to stay in a house for a long period of time (like more than 10 years). For example, SoFi offers fixed-rate mortgages with 15- and 30-year loan terms. This means the rate you receive up front will stay the same for 15 or 30 years, respectively.
Bottom line: If you are planning to own your home for the long-term and want to avoid the uncertainty of a variable interest rate, consider choosing a fixed-rate loan.
Adjustable-Rate Mortgage Loans
In a nutshell: lower rates, more risk
An adjustable-rate mortgage (ARM) loan is so named because the interest rate changes over time. In many cases, an ARM loan’s rate will stay the same for a specified period of time, such as five to seven years. After this introductory period, the mortgage rate will begin to change — usually once per year.
ARM loans are usually labeled with numbers that delineate a) the length of the introductory fixed phase, and b) the frequency of rate adjustments following the fixed phase. For example, SoFi offers a 7/1 adjustable-rate mortgage that has a fixed interest rate for the first seven years, after which time the rate changes annually based on the 1-Year LIBOR index. And for many first time home buyers or others who plan to move, they still have the option to leave the loan before the seven year fixed period ends with no prepayment penalty.
So why would anyone want a mortgage loan with a rate that changes over time? Why choose an ARM over the stability of an FRM? The reason can be summed up in a single word—savings. Borrowers who choose adjustable mortgage loans tend to secure lower initial interest rates than those who use fixed-rate loans.
If you’re concerned about the risk of rising interest rates, many ARM loans have caps on how much the interest rate can increase or decrease. There is usually both an annual limit and a lifetime limit. For example, an ARM loan may specify that the maximum interest rate adjustment each year cannot be more than 2%, and cannot be more than 5% over the life of the loan.
As you can see, different types of home loans offer different pros and cons. As a borrower, consider your financial goals and your long-term plans, then choose a mortgage option that best supports those goals.
Download the SoFi Guide to First Time Home Buying to get valuable tips on these topics and more. Our guide also demystifies modern mortgage myths around down payments, the pre-approval process, student loans, rising interest rates, and more.
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