Should you get a fixed rate or adjustable-rate mortgage?
When talking about investing in real estate, you practically only hear about the 30-year conventional home loan — the type you would get to buy your primary residence. But not only are there other options, some offer perks like low downpayments that could be utilized. Some have strong guidelines, some do not.
Whichever you choose, you'll always be met with the same question. Should I get a fixed rate or an adjustable-rate mortgage?
This article will discuss these two interest rate types. As with most things, the answer is "it depends."
Fixed Rate vs. Adjustable-rate Mortgage
To review, a mortgage payment is broken up into two components — principal (paying down the loan) and interest (the cost of borrowing money). While the principal is fixed, the interest on the other hand can be chosen to be fixed or not.
Fixed Interest
Fixed-rate mortgages means that the interest rate stays the same throughout the lifespan of your loan. The byproduct of this, is that the monthly payment also will stay the same throughout the lifespan of your mortgage, which makes it easier to budget for the cost.
However, locking in a fixed interest rate can be a double-edged sword. It is better for you if the interest rates rise since you are locked in at your negotiated rate. However, if the interest rate decreases, you'll be at a loss since you could be borrowing money at a lower rate than your locked-in rate.
Generally, most people prefer the consistency of a fixed-rate mortgage for investment properties. It makes the accounting and financing process much simpler since the mortgage payment will remain the same similar to how rent payments are the same. It also generally makes more sense over the long term.
Adjustable-rate Mortgages
Adjustable-rate mortgages have interest rates that can change throughout the mortgage timeline. It can go up or down depending on the financial interest rate index that the bank is using and discloses in your contract.
Interestingly, adjustable-rate mortgages generally have an initial "grace" period where the interest rate is fixed. For example, a 5-year/6-month adjustable rate mortgage means that the interest rate is fixed for the first 5 years and has the potential to change once every 6 months after.
This introduces a bit less interest rate risk in case the interest rates happen to go down. By flipside, if the interest rates go up, you must pay more money. This means your monthly mortgage payment may be variable.
Generally, most people dislike these because variable payments can cause issues in accounting. Because rent is usually fixed, there could potentially be a period of time where the monthly payment goes up and the rental payment may not cover it.
Which is better?
It depends.
For most borrowers, adjustable-rate mortgages offer lower interest rates overall compared to a fixed mortgage at the same point in time. For example, if you were to get a 2.875% mortgage fixed rate today, you potentially may get a similar 2.35% offer on an adjustable-rate instead. While the percentage seems small, the small change could mean hundreds of dollars or even thousands of cash flow difference for you.
Moreover, most adjustable-rate mortgages do not require that you sign on for 30 years. In fact, 5, 7, or 10 years are the most common versions of this loan type. This means that you aren't exactly tied down for an entire lifetime.
And to tie this all together, they really only make sense if interest rates are high. In the case of 2020-2021 during the pandemic (the time of writing), the interest rates for fixed loans are so low, that it may be smart to lock that interest rate in for a long-term investment. We are seeing most people get around 3% interest rates for loans. 5-years before, that interest rate was closer to the 4% range.
Conclusion
They both could be good loans. It depends on which risk you are willing to take. Both can be great tools for investors to utilize to meet their investment needs.