Real estate investing involves a lot of decisions that have an impact on your success in the industry. When it comes to investment property financing, one crucial decision you’ll need to make is to choose the type of mortgage to take – adjustable-rate mortgage vs fixed-rate mortgage. A mortgage lender will typically offer both interest rates on investment loans. But is a fixed rate or adjustable rate better?
To help you make a smart choice, we have written this adjustable-rate mortgage vs fixed-rate mortgage guide. Read on to learn the difference between these two types of loans and how to choose the best one for your needs.
Related: 8 Best Investment Loans for Real Estate in 2020
Adjustable-Rate Mortgage vs Fixed-Rate Mortgage: What’s the Difference?
1. Fixed-Rate Mortgage
A fixed-rate mortgage means that your interest rate is locked in for the life of the loan. Therefore, your monthly payments over the life of your loan will also remain constant regardless of changes in economic conditions. This is the most popular mortgage type.
Traditional lending institutions usually offer fixed-rate mortgages for different terms such as 15, 20, and 30 years. Most borrowers prefer the 30-year mortgage because it offers the lowest monthly mortgage payment. However, the overall cost is usually higher because you’ll be paying more in interest.
Pros of a Fixed-Rate Mortgage
A real estate investor may consider a fixed-rate mortgage because of the following reasons:
Makes Budgeting Easier
Since your monthly payments are standardized, you can manage your money with more certainty. This makes it the safer mortgage type for real estate investors who are planning to hold their rental property for years and don’t want to gamble on real estate market fluctuations.
Peace of Mind
Stability of mortgage payments offers real estate investors the peace of mind they need to focus on other important things. They don’t have to worry about the interest rate on their mortgage going up.
Cons of Fixed-Rate Mortgages
May Limit Your Maximum Loan Amount
The downside of fixed-rate mortgages is that they usually have a higher starting interest rate than ARMs. High investment property mortgage rates limit the loan amount you can afford.
It’s Hard to Take Advantage of Falling Rates
In case interest rates go down, you won’t be able to take advantage of them without refinancing. Your interest rate will remain stuck at the initial, higher level. This means that you may end up paying a higher rate than for an ARM.
2. Adjustable-Rate Mortgage
An adjustable-rate mortgage (ARM), also known as a variable-rate mortgage, usually starts out at a fixed interest rate for a specified initial period after which the interest rate may start adjusting at a pre-arranged frequency depending on market indexes.
This means that your monthly payments can change over time. Consequently, how much will be owed over the life of the mortgage can also change. Since it’s hard to predict where the interest rates will go, your mortgage payments have the potential to decrease or increase.
Pros of ARMs
Lower Initial Payments
The initial interest rate and monthly payments of ARMs are typically lower than those of a similar fixed-rate mortgage. Therefore, an ARM may be suitable for investors who want more cash flow flexibility in the near term, and if interest rates are expected to go down in the future.
You Can Qualify for a Bigger Loan
Since the interest rate at the initial fixed period is usually lower than that of a fixed-rate mortgage, you’ll be able to qualify for a bigger loan. Moreover, you can save more money over the short-term because of smaller monthly payments.
You Can Easily Take Advantage of Falling Rates
If interest rates are falling, a real estate investor can enjoy lower monthly payments without the need to refinance.
Cons of ARMs
You Are Not Protected From Potential Increases in Interest Rates
While ARMs can offer lower initial rates, once the initial fixed-rate period elapses, the rates may go up, sometimes higher than that of a fixed-rate mortgage. Sudden and significant increases in monthly mortgage payments can really damage your cash flow. Being a riskier loan, lenders typically use lower initial rates to make them more attractive.
It’s More Complicated
Adjustable-rate mortgages are usually more complicated than fixed-rate mortgages. There is more to the loan and even more terminology that you’ll have to understand and familiarize yourself with.
Deciding on the Type of Loan to Take
You can now differentiate between the two types of loans (adjustable-rate mortgage vs fixed). However, which is better? Why should you choose one over the other?
When shopping for a mortgage to finance your real estate investment, there’s rarely a clearly defined right or wrong answer. The fact is that each type of loan has its own benefits and drawbacks. Therefore, as a real estate investor, you should choose one that best suits your needs.
When to Choose a Fixed-Rate Mortgage
Fixed-rate mortgages are more suitable when interest rates are low and are expected to go up in the future. With the negative impact of the COVID-19 pandemic on the economy, interest rates are near historical lows. Therefore, locking in the current low rates could be a wise decision.
If you want predictable monthly payments and stable cash flow for the long term, a fixed-rate mortgage may also be the better choice.
Related: Mortgage Rate Locking: What Does It Mean and When to Do It?
When to Choose an ARM
Adjustable-rate mortgages are best for investors who are planning to have a shorter holding period, say five or seven years. A lower initial rate may increase your cash flow as you plan to sell the property before the rental property mortgage rates begin to adjust.
An ARM mortgage can also work well if interest rates are high but are expected to drop. However, since it’s hard to predict how interest rates will go with certainty, you’ll need to budget for potentially higher rates once your fixed-rate period ends.
If you are considering an ARM, it’s important that you run the numbers to determine the worst-case scenario. Could you afford the mortgage payments if interest rates go up significantly?
Using Mashvisor’s Calculator
With Mashvisor’s investment property calculator, you can easily estimate the profits you’d get for different mortgage options and pick the best for your real estate investment. You simply specify the following mortgage details:
- Property price
- Down payment
- Loan amount
- Mortgage type (adjustable-rate mortgage vs fixed-rate mortgage)
- Loan term
- The interest rate
Related: How to Get the Best Rental Property Mortgage Rates in 2020
The Bottom Line
If you are shopping for a mortgage, you need to take your time and weigh the merits and demerits of an adjustable-rate mortgage vs fixed-rate mortgage. The better type of loan will depend on what best fits your situation and investment goals.