The mortgage is usually the largest debt a household will take on. The choice between a fixed-rate and an adjustable-rate mortgage is a choice about how the household wants to hold interest-rate risk. Understanding the tradeoff before signing is the difference between an informed choice and an accident.
- 01Distinguish a 30-year fixed from a 15-year fixed from an ARM.
- 02Compute the total interest cost of each on the same principal.
- 03Choose defensibly among them for a specific household.
The 30-year fixed
The dominant American mortgage. Rate locked for the entire term. Payment predictable to the penny. The interest cost over 30 years typically exceeds the original principal at rates above 5%. The prepayment option is valuable when rates fall.
The 15-year fixed
Same rate lock, shorter term, higher monthly payment, dramatically lower total interest cost. On a $500,000 loan, moving from 30 years at 7% to 15 years at 6.25% roughly halves the total interest paid over the life of the loan.
The ARM
Fixed for an initial period (5, 7, 10 years), then adjusting annually with a rate cap. Suits households that have a defensible plan to move or refinance within the initial period. Suits no one who plans to hold for the full term.
- Fixed rate is a choice about risk, not a default.
- 15-year cuts total interest by nearly half.
- ARMs suit households with a definite short horizon.