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When you get a mortgage, there are many loan features to consider. One of the key decisions is whether to go with a fixed- or adjustable-rate loan. In today’s rising-rate environment, adjustable -rate mortgages (ARMs) can be appealing due to their lower initial rates, but they have significant risk. Fixed-rate mortgages alleviate a lot of stress, but can mean paying more money.
Each type of loan has pros and cons. Let’s compare and contrast adjustable-rate vs. fixed-rate mortgages.
Fixed-rate vs adjustable rate mortgages
What is a fixed-rate mortgage?
A fixed-rate mortgage has the same interest rate for the life of the loan. In other words, your monthly payment of principal and interest won’t change. (Note: your mortgage payments can fluctuate as your property taxes or homeowners insurance change over time, because those costs are usually wrapped into your loan payments in escrow.)
These loans get their popularity from the predictability and stability they offer, but they can come with a higher interest rate than an ARM — at least at first.
The most popular type of fixed-rate mortgage — in fact, the most popular mortgage, period — is the 30-year fixed-rate loan. At an interest rate of 7.26 percent with no money down, a $300,000, 30-year fixed loan will have monthly payments of around $2,048, not including insurance or taxes.
Pros of a fixed-rate mortgage
- Rates and payments remain constant.
- Monthly stability of payments makes household budgeting easier.
- Simple to understand, especially for first-time buyers.
Cons of a fixed-rate mortgage
- If interest rates fall, fixed-rate mortgage borrowers have to refinance to take advantage.
- It could cost more in interest over the life of the loan if you secure the loan at a higher rate and you don’t refinance if rates drop.
- It is virtually identical from lender to lender and generally cannot be customized.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can change periodically.
This means that the monthly payments can go up or down throughout the life of the loan. Generally, the initial interest rate is lower than that of a comparable fixed-rate mortgage in the beginning. After the fixed-rate period ends, the interest rate on an ARM loan moves based on the index it’s tied to.
The index is an interest rate set by market forces and published by a neutral party. There are many indexes, and your loan paperwork identifies which index a particular adjustable-rate mortgage follows..
The most popular adjustable-rate mortgage is the 5/1 ARM. The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.) After that, the interest rate can change once a year. (That’s the “1” in 5/1.) Some lenders also offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.
At an interest rate of 5.53 percent, the monthly payment for the first five years on a $300,000 30-year 5/1 ARM would be around $1,709, not including taxes or insurance.
Pros of an adjustable-rate mortgage
- It has lower rates and payments early in the loan term. Because lenders can consider the lower payment when qualifying borrowers, people can buy more expensive homes than they otherwise could.
- It allows borrowers to take advantage of falling rates without refinancing.
- It can help borrowers save and invest more money. Someone who has a payment that’s $100 less with an ARM can put that money in a higher-yielding investment.
- It offers a cheaper way to buy a house for borrowers who don’t plan on living in one place for very long.
Cons of an adjustable-rate mortgage
- Rates and payments can rise significantly over the life of the loan.
- Some annual caps don’t apply to the initial loan adjustment.
- ARMs are more complex than their fixed-rate counterparts, including features like margins, caps and adjustment indexes.
What’s the difference between fixed-rate and adjustable-rate mortgages?
ARMs and a fixed-rate mortgages come with some key differences:
- The initial interest rate: An ARM typically has a lower initial interest rate than a fixed-rate loan. That means the monthly payment during the introductory period of an ARM is lower than the payment of a fixed-rate mortgage.
- The interest rate over time: After the ARM’s initial rate period, however, the rate and monthly payment can rise. Although there’s a limit to how much your rate can increase, it can still climb considerably, and you could wind up with an unaffordable monthly payment after the first few years of your loan term. A fixed-rate mortgage, by contrast, has a fixed payment throughout the life of the loan, and the rate and payment won’t change unless you refinance to a different loan.
- The down payment: ARMs generally require a slightly higher down payment of 5 percent. For some fixed-rate conventional loans, you can put down just 3 percent. If you don’t have much saved up, this might be your deciding factor when weighing fixed-rate vs. adjustable-rate mortgages.
ARM vs. fixed: mortgage payments examples
|5/1 ARM||30-year FRM|
|Monthly payment||$1,709 for first 5 years, then adjusts based on new rate||$2,048 for 30 years|
ARM vs. fixed: Which should I choose?
Now that you’ve got the ARM and fixed-rate mortgage basics, here are important questions to ask when deciding which loan is right for you.
How long do you plan on staying in the home?
If you’re going to be living in the house for only a few years, it can make sense to take a lower-rate ARM, especially if you can get a reasonably priced 3/1 or 5/1. Your payment and rate will be lower, and you can build savings for a bigger home down the road. Plus, you’ll never be exposed to huge rate or payment adjustments because you’ll be moving before the adjustable-rate period begins.
How frequently does the ARM adjust?
After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage. The new rate is actually determined by the index value about 45 days before the anniversary, based on the specified index, but some adjust as frequently as every month. If that’s too much volatility for you, go with a fixed-rate mortgage.
What’s the interest rate environment like?
When you’re weighing ARM vs. fixed, look at current interest rates. When rates are falling, borrowers have a decent chance of getting lower payments even if they don’t refinance.
When rates are relatively low, however, fixed-rate mortgages make more sense. Rates are currently on the rise, so ARMs will be more affordable upfront, but you might see your payments grow massively once the rate lock expires.
Can you still afford your payments if rates jump?
ARM payments vary considerably and can change significantly from year to year as market conditions shift. On a $150,000 one-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent ARM could rise to 11.75 percent, with the monthly payment shooting up as well. Experts say that when fixed mortgage rates are low, fixed mortgages tend to be a better deal than an ARM, even if you plan to stay in the house for only a few years.
Final word on fixed- vs adjustable-rate mortgages
Adjustable-rate mortgages and fixed-rate mortgages are two ways to finance a home purchase. ARMs usually have lower initial payments, but those can rise after the initial rate period. This makes them ideal for people who plan to move or refinance their loan after a few years.
Fixed-rate loans are typically more expensive upfront, but are more predictable in that your monthly payments don’t change. This makes them better for people who plan to stay in their new home for the long term, need stability in their budget or both.
Overall, your decision about ARMs vs fixed-rated mortgages should be guided by your budget, your housing needs — and your appetite for financial risk.