A mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home or property. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value.

The loan must be paid back over time. The home purchased acts as collateral on the money an individual is lent to purchase the home.

Fixed-Rate Mortgages

Fixed-rate mortgages provide borrowers with an established interest rate over a set term of typically 15, 20, or 30 years. With a fixed interest rate, the shorter the term over which the borrower pays, the higher the monthly payment. Conversely, the longer the borrower takes to pay, the smaller the monthly repayment amount. However, the longer it takes to repay the loan, the more the borrower ultimately pays in interest charges.

The greatest advantage of a fixed-rate mortgage is that the borrower can count on their monthly mortgage payments being the same every month throughout the life of their mortgage, making it easier to set household budgets and avoid any unexpected additional charges from one month to the next. Even if market rates increase significantly, the borrower doesn’t have to make higher monthly payments.

Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) come with interest rates that can – and usually, do – change over the life of the loan. Increases in market rates and other factors cause interest rates to fluctuate, which changes the amount of interest the borrower must pay, and, therefore, changes the total monthly payment due. With adjustable rate mortgages, the interest rate is set to be reviewed and adjusted at specific times. For example, the rate may be adjusted once a year or once every six months.

One of the most popular adjustable-rate mortgages is the 5/1 ARM, which offers a fixed rate for the first five years of the repayment period, with the interest rate for the remainder of the loan’s life subject to being adjusted annually.

While ARMs make it more difficult for the borrower to gauge spending and establish their monthly budgets, they are popular because they typically come with lower starting interest rates than fixed-rate mortgages. Borrowers, assuming their income will grow over time, may seek an ARM in order to lock in a low fixed-rate in the beginning, when they are earning less.