Fixed-rate and adjustable-rate mortgages each offer distinct advantages and disadvantages. While the traditional 30-year fixed-rate mortgage is still the most popular option, an adjustable-rate mortgage (ARM) may be the better choice in some situations. Here’s how each loan type works and how to decide which type is right for you.
A fixed-rate mortgage has an interest rate that is fixed for the life of the loan. These are the most common type of mortgage as they offer the predictability of a principal and interest payment that will never change. (As with all mortgages, the property tax and homeowner’s insurance portion of your mortgage bill can change, however.) Most fixed-rate mortgages are for 30-year terms, but other terms, such as 15-year, are also available.
An adjustable-rate mortgage has an interest rate that can change at certain times and within certain limits. Typically, ARMs start with a fixed rate for an introductory period of several years. After that period ends, the interest rate changes every adjustment period (usually each year). Lenders do not get to choose each interest rate adjustment, but instead, the rate adjustment is tied to a popular interest rate market measure known as an index. This means the interest portion of your mortgage payment can go up or down each adjustment period.
Since no one can fully predict the future of interest rates, ARMs often have limits on how fast and how much their rates can adjust after their introductory periods end. These limits are known as caps. The three types of caps are as follows:
- Initial cap: a limit on how much the rate can change during the first adjustment period
- Periodic cap: a limit on how much the rate can change during every adjustment period
- Lifetime cap: a limit on how much the rate can change over the life of the loan
The name of each specific ARM product shows how long the introductory period lasts and how often the rate adjusts after that.
Some examples include the following:
- 7/1 ARM: the rate is fixed for 7 years and then adjusts every 1 year
- 5/5 ARM: the rate is fixed for 5 years and then adjusts every 5 years
The adjustable-rate advantage
The main benefit of an ARM is that the rate for the introductory period is usually lower than the rate available on similar fixed-rate mortgages. For example, on a $200,000 conventional loan, a 7/1 ARM may be available with a rate of 3.500% (3.913% APR), whereas a 30-year fixed-rate mortgage may be available at 4.000% (4.101% APR). In that case, over the seven-year introductory period, the ARM’s mortgage payment would be $57 lower per month for a total savings of $4,788. The bigger the loan amount, the bigger the difference in interest rates between the loan types and the longer the introductory period, the bigger the potential savings.
Of course, an ARM can also end up costing more than a fixed-rate mortgage if it is held past its introductory period and its rate adjusts upward rather than staying the same or dropping. However, people who sell their home or refinance their mortgage before the introductory period ends can claim the savings before the adjustment period even arrives. Because of this, ARMs are becoming more popular for borrowers in the United States.
How to choose
Which type of mortgage you select should depend on how long you plan to keep your home or mortgage, the difference in interest rates available to you between the two loan types and the amount of risk you’re willing to accept.
If you plan to live in your home for several years longer than the introductory period on an ARM, if the difference in rates between the two loan types is minimal or if you’re uncomfortable with the risks of an ARM, a fixed-rate loan may be best for you.
If you plan to sell your home or refinance before the introductory period of an ARM ends, if the rate difference between the loan types is significant and if you’re okay with some extra risk, an ARM may be the right choice for you.
Ultimately, you should consult with a loan officer and potentially a financial advisor to evaluate the loan options that are available to you and the financial benefits and risks associated with each. By thinking outside the fixed-rate mortgage box, you may be able to come out ahead by choosing an adjustable-rate mortgage in the right situation.