If you’re about to take out a home loan, it’s important to understand the differences between a fixed-rate and adjustable-rate mortgage (ARM).
For instance, you might be wondering why most people get fixed-rate mortgages when adjustable-rate mortgages have lower interest rates.
What is an ARM?
An ARM is an adjustable-rate mortgage. For the first few years, your interest rate will remain fixed before adjusting periodically after that. Since your rate adjusts periodically following the initial fixed period, your monthly mortgage payment may change as well.
For example: A 5/1 ARM — one of the most common types of ARMs — has an initial interest rate period of five years. After that, the rate adjusts once annually.
The starting interest rate is the one you’ll see when shopping for an ARM. So, if you see a 5/1 ARM advertised at 3%, your interest rate will be 3% for the first five years of the term.
Learn more about different ARMs:
Pros of an ARM
- Smaller monthly mortgage payments at first: An adjustable-rate mortgage will typically have a lower initial interest rate compared to a 30-year fixed-rate mortgage. Since both loans are amortized over the same number of years, the ARM will have a lower monthly payment because of its lower rate.
- Lower interest expense: Over an ARM’s initial fixed period, you’ll spend less money on interest. This means more savings for you — at least, in the short term.
- Rates can go down: They’re not called “increasing-rate mortgages.” An ARM’s rate can go down, too.
- Pay down principal faster: With the smaller monthly payment from a lower interest rate, you may be able to pay extra toward your mortgage’s principal balance. Those additional payments will increase your equity faster and reduce how much interest you’ll owe later.
Tip:
You will not necessarily qualify to borrow more with an ARM. Your lender will want to make sure you can pay your mortgage even after the rate adjusts. To verify this, they will use a higher rate than the initial rate when deciding how much you can borrow.
Cons of an ARM
- Monthly payments may rise. If interest rates go up between now and when your ARM resets, the index will probably be higher. Your loan will then cost you more each month.
- Larger interest expense long term. If you end up keeping your ARM until the end of its 30-year term and interest rates rise, you could pay more interest overall than if you had taken out a fixed-rate mortgage.
- More complicated. The index, margin, frequency of adjustments, and interest rate caps mean there’s a lot you need to understand with an ARM. If you’re confused about how your loan works, you could end up owing more than expected.
- Payments could become unaffordable. An ARM’s interest rate caps make it possible to budget for the worst-case scenario of a significantly higher monthly payment. Still, you may not have the income to support that payment if it comes to pass.
Be careful! Don’t assume you’ll be able to refinance or sell. If your ARM rate rises to a level you aren’t happy with, you may be stuck with it.
The housing market and mortgage market, your employment, and/or your credit could make it difficult for you to get a good mortgage rate — or sell your property entirely.
How ARM rates work
ARM rates are determined by an interest rate index set by the market plus a margin set by the lender. For instance, if your margin is 2 percentage points and the index rate is 0.15%, then your interest rate would be 2.15%.
Good to know: An ARM also has interest rate caps. These limit the amount your interest rate can rise at each adjustment period.
For example, the cap might be two percentage points above the initial interest rate per year and five percentage points above the initial interest rate over the life of the loan.
What is a fixed-rate mortgage?
A fixed-rate mortgage has the same interest rate for the entire loan term. That’s the biggest difference between fixed and adjustable-rate mortgages.
The most common type of mortgage is the 30-year fixed. The second-most common is the 15-year fixed. Some lenders let you customize the term to, say, 19 years or 24 years.
Pros
- Predictable monthly payment. A fixed-rate mortgage will give you the same monthly principal and interest payment over the life of the loan.
- Predictable total interest expense. You can look at a loan amortization table to find out exactly how much overall interest you’ll pay on the loan for any length of time.
- Easy to understand. If you’re not financially sophisticated — and even if you are — the simplicity of a fixed-rate loan offers peace of mind.
Cons
- Monthly payments can’t go down. Refinancing is the only way to lower your rate on a fixed-rate mortgage. By comparison, the interest rate on an ARM could potentially reset to a lower rate.
- Larger interest expense over the initial period. A 30-year fixed-rate loan will cost more than an ARM over the ARM’s initial period. However, if you can afford the higher monthly payment of a 15-year fixed-rate loan, you could pay even less interest than you would with an ARM.
- Principal paydown may be slower at first. Since you’re paying more interest, you’ll be paying less principal than you would for the same monthly payment on an ARM.
The difference between ARMs and fixed-rate mortgages
The basic requirements to qualify for a mortgage are similar between ARMs and fixed-rate loans. The main differences between the two are their cost and risk.
Here’s how an adjustable-rate mortgage compares with a 30-year fixed-rate mortgage:
How to choose between ARMs vs. fixed-rate mortgages
Selecting the right mortgage depends on your circumstances. Here are some scenarios to consider if you’re deciding between a fixed-rate mortgage and an adjustable-rate mortgage.
When to choose an ARM
- You plan to move in a few years. Are you in the military or another job that will require you to move again soon? An ARM can be a good way to enjoy the stability of homeownership at a lower cost while in your current position.
- You can afford the risk of paying a higher rate later. During the housing bubble of the early 2000s, lenders used an ARM’s initial rate to qualify borrowers who needed the lowest possible monthly payment. Many of those borrowers lost their homes to foreclosure when their ARMs reset. Make sure you can afford the risk of higher interest later on when your ARM resets.
- Interest rates seem likely to go down in the long run. That’s not the case right now, but borrowers in the high interest-rate environment of the 1980s flocked to ARMs, which were new to the United States at the time.
When to choose a fixed-rate mortgage
- You’ve found your forever home. If you don’t anticipate moving and want to own your home mortgage-free someday, locking in a fixed rate is a smart strategy when rates are low.
- You don’t want to risk a rate increase. There’s nothing wrong with paying a little more now for security later. After all, stability is one reason many people enjoy owning a home over renting.
- Interest rates seem likely to go up in the long run. Since interest rates are near historic lows right now, they’re more likely to increase than decrease in the long run.
