Fixed vs. Adjustable Rate Loans
Have you ever gotten confused when looking for a loan? Which rate type is better? How is the payment calculated? And what is an ARM?
Fixed Rate Loan
A Fixed Rate Loan, also known as a conventional loan, is a loan in which the interest rate remains the same during the life, or term, of the loan. This allows the monthly payment to remain the same the term of the loan.
The monthly payment is a combination of interest plus principal. Initially the monthly payment will be made up of more interest than principal. (The higher the principal, the higher the interest amount repaid). As the loan is repaid, the principal shrinks, as does the interest repaid. Therefore, at the beginning of the loan, most of the payment goes towards interest while most of it goes towards principal at the end of the loan. Due to the nature of the Fixed Rate, or conventional loan, most loans are Fixed Rate.
Common Types of Fixed Rate Loans are auto loans, student loans and most 15-to-30 year mortgages.
Adjustable Rate Loans (ARM)
An Adjustable Rate Loans (ARM), also known as a variable rate loan, is a loan in which the interest rate varies according to the Federal Reserve. An Adjustable Rate Loan typically begins with an initial interest rate fixed for specific term. After this initial fixed rate term, an Adjustable Rate Loan will be reset according to the current rate.
As in a Fixed Rate Mortgage, the monthly payment is a combination of interest plus principal. Initially the monthly payment will be made of up more interest than principal. (The higher the principal, the higher the interest amount repaid). As the loan is repaid, the principal shrinks, as does the interest repaid. Therefore, at the beginning of the loan, most of the payment goes towards interest while most of it goes towards principal at the end of the loan. Due to the varying nature of the rate and payment, Adjustable Rate Loans are not as common as Fixed Rate Loans.
Common types of Adjustable Rate Loans are various mortgages and credit cards.
