What are the advantages of fixed rate versus adjustable rate loans?

With a fixed-rate loan, your monthly payment of principal and interest never change for the life of your loan or the fixed rate period promised in your note. 

Fixed-rate loans are available in all sorts of shapes and sizes: 30-year, 20-year, 15-year even 2-10 year terms. Some fixed-rate mortgages are "biweekly" mortgages and may shorten the life of your loan. You pay every two weeks, a total of 26 payments a year -- which adds up to an "extra" monthly payment every year.

During the early amortization period of a fixed-rate loan, a large percentage of your monthly payment goes toward interest, and a much smaller part toward principal. That gradually reverses itself as the loan ages. Often times an interest only loan can make more sense and by adding principle balance to the payment you can often times pay off your loan quicker.

You might choose a fixed-rate loan if you want to lock in a low rate. If you have an Adjustable Rate Mortgage (ARM) now, refinancing with a fixed-rate loan can give you monthly payment stability.

Adjustable Rate Mortgages -- ARMs, as we called them above -- come in even more varieties. Generally, ARMs determine what you must pay based on an outside index, perhaps the 6-month Libor rate, the 12 month Treasury rate (MTA), the Federal Home Loan Bank's 11th District Cost of Funds Index (COFI), or others. They may adjust every six months or once a year or in some cases monthly.

Most programs have a "cap" that protects you from your monthly payment going up too much at once. There may be a cap on how much your interest rate can go up in one period -- say, no more than one percent per year, even if the underlying index goes up by more than one percent. You may have a "payment cap," that instead of capping the interest rate directly caps the amount your monthly payment can go up in one period. In addition, almost all ARM programs have a "lifetime cap" -- your interest rate can never exceed that cap amount, no matter what.

ARMs often have their lowest, most attractive rates at the beginning of the loan, and can guarantee that rate for anywhere from a month to ten years. They also offer some of the most lenient fixed rate quidelines and can be the best programs for jumbo loans in todays market. You may hear people talking about or you may read about loans that are called "3/1 ARMs" or "5/1 ARMs" or the like. That means that the introductory rate is set for three or five years, and then adjusts according to an index every year thereafter for the life of the loan.

You might choose an ARM to take advantage of a lower introductory rate and count on either moving, refinancing again or simply absorbing the higher rate after the introductory rate goes up. With ARMs, you do risk your rate going up, but you also take advantage when rates go down by pocketing more money each month that would otherwise have gone toward your mortgage payment.