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Mortgage basics: 10/1 ARM vs. 30-year fixed-rate mortgage

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@TonyTheTigersSon/Twenty20
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@TonyTheTigersSon/Twenty20
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When it comes to buying or refinancing an existing mortgage, no two situations are exactly the same. That’s why there are a variety of types of mortgages and term lengths available. If you’re starting to compare your options for borrowing, you might be making a list of pros and cons between a 10/1 ARM and a 30-year fixed mortgage. Both of these mortgages can fit under the conventional loan category, but they have some key differences. Here’s a rundown of everything to consider.

How do ARMs and fixed-rate mortgages differ?

Fixed-rate mortgages are appropriately named: They come with a rate and a monthly payment that never changes. They tend to come in two main packages – 15-year and 30-year, with the 30-year fixed-rate mortgage being a consumer favorite. By locking in your rate, your monthly payments stay exactly the same, giving you no surprises about your loan cost over time and making it easier to budget for the future.

With an ARM, however, the interest rate will change after a set period of time. ARMs are typically expressed in two numbers. The first number identifies the period when the loan’s interest rate is fixed, and the second number indicates the frequency the interest rate is adjusted following the initial fixed period. After the introductory period is over, the interest rate and the payments will regularly adjust based on market conditions. ARMs are a bit of a gamble: Your rate might go up, or it might go down. Most ARMs set a cap on how much your interest rate can increase each year, along with a lifetime increase cap.

How does a 10/1 ARM work?

For the first 10 years, a 10/1 ARM functions just like a fixed-rate mortgage. The rate and the payments are the same. Then, once the clock strikes a decade, the interest rate resets every year. So, let’s say you close your loan on September 30, 2022. On September 30, 2032, your interest rate will change – moving either up or down based on movement in the benchmark interest rate that helps determine the adjustment. Then, every year on that anniversary, the rate will adjust again until you pay off the loan, sell the home or refinance the mortgage. Each time the rate changes, your minimum monthly payment amount changes, too, to reflect the difference in interest.

Comparing a 10/1 ARM with a 30-year fixed-rate mortgage

ARM rates tend to look more attractive because they are usually lower than those attached to 30-year mortgages. Let’s compare a 10/1 ARM with a 5.19 percent APR with a 30-year mortgage with a 6 percent APR for a glimpse of how the first 10 years looks:

10/1 ARM 30-year fixed rate mortgage
APR 5.19% 6%
Monthly payment $2,389.20 $2,193.97
Remaining principal after 10 years $334,743.23 $327,216.55

Over the first 10 years, the 10/1 ARM is a clear winner: You save more than $200 per month to free up additional room in your budget, and you make a bigger dent in the principal balance.

Once the introductory period is over, though, you could be in for a potentially rocky road. Let’s say that your ARM has a lifetime cap of 10.19 percent (a total of maximum increase of 5 percent). In that case, your monthly payment could wind up jumping as high as $3,168.63  if you hold on to the loan long enough.

Important considerations

If you’re comparing a 10/1 ARM vs. a 30-year fixed-rate mortgage, be sure to think about the following questions to help shape your decision.

How much are you saving? The big reason to consider a 10/1 ARM is the potential for a lower minimum monthly payment. So, do the math to determine whether the savings now is worth the potential uncertainty in the future.

What is your plan for the extra money you might save with an ARM? Saving money only matters if you know what you’re going to do with it. Will you make additional payments to the principal to accumulate equity faster? Or can you use the money to pay off other debt like student loans? Could some of the money go toward your retirement fund?

How long are you planning to be in the home? If this home is a starter home, a 10/1 ARM can be a wise choice. By selling the property in the first 10 years, you’ll never even have to worry about what an interest rate adjustment means for your budget.

Can you afford the worst-case scenario? Even if you have plans to sell the home before the 10-year-marker arrives, your plans might change. So, make sure you are considering the downsides. What will you do if you cannot sell the home? What happens if the time to adjust arrives and you’re unable to score a competitive refinance rate? While it’s impossible to predict the future, you can take steps to think about how an increase in the rate could impact your lifestyle.

Bottom line

Determining whether a 10/1 ARM is a better choice than a 30-year fixed-rate mortgage involves a range of considerations about your financial well-being and your long-term plans for the property. Ultimately, if you can lock in a lower interest rate and you expect to be in the home for less than a decade, the 10/1 ARM can be a smart move.