Adjustable versus fixed-rate mortgages

Get to know the difference between a fixed-rate mortgage and an adjustable-rate mortgage. Watch this quick video to hear the pros and cons of both mortgages.

Key takeaways

• The interest rate and monthly payment on a fixed-rate mortgage don’t change, which may offer predictability and stability.
• An adjustable-rate mortgage, or ARM, typically offers a lower interest rate for an initial fixed period; then your interest rate has the potential to increase or decrease periodically depending on the market conditions.
• Fixed-rate mortgages may be a good option if you plan to stay in your home for a long time. On the other hand, an ARM loan might be a great option if you plan to move within a few years.

If you’re buying a home, you’re probably crunching a lot of numbers, like home prices, down payments, terms and interest rates. But more than that, you’re probably also asking yourself questions like, how long do I plan to stay in this home?

If you’re planning to stay in the home for a long time and want consistency in your monthly payments and interest rate, you may want to consider a fixed-rate mortgage. But if you think you won’t be in the home long term and plan to sell before the initial fixed-rate period adjusts, you may be able to save money with an adjustable-rate loan.

Deciding which loan type is best for you depends on your financial situation, your goals and your risk tolerance. Here, we’ll explore adjustable-rate mortgages vs. fixed and weigh the pros and cons of each.

Understanding adjustable-rate mortgages

Adjustable-rate mortgages, or ARMs, are home loans with an interest rate that changes over time. A traditional ARM offers a lower interest rate for a fixed period at the beginning of the loan term. During this period, you have a fixed principal and interest mortgage payment. Once this period ends, your interest rate has the potential to increase or decrease periodically, which can change your monthly payment.

There’s another adjustable-rate mortgage option called an interest-only ARM. The main difference between this and a traditional ARM is that you make interest-only (no principal) payments during the stated period.

Adjustable-rate loans can be complicated and hard for a newer homebuyer to understand. There are several types of ARMs, each with its own features and terms, like caps, indexes and margins. The following table provides a breakdown of key terms:

How do adjustable-rate mortgages work?

There are two different time periods for an ARM loan:

• Fixed period: During this initial time, the loan’s interest rate doesn’t change. Common fixed periods are three, five and 10 years. This lower interest rate is sometimes called an introductory period or teaser rate.
• Adjusted period: After the fixed or introductory period ends, the rate applied to the remaining loan balance can change periodically, increasing or decreasing based on market conditions. Most ARMs have caps or ceilings that limit how much the interest rate can increase over the life of the loan.

A common adjustable-rate mortgage is a 5/1 ARM, which has a fixed rate for the first five years. After the initial fixed period, the interest rate adjusts once per year based on interest rate conditions. A 5/6 ARM has the same five-year fixed rate, with the interest rate adjusting every 6 months after the fixed period.

The benefits of ARMs

An ARM loan can be a smart choice for people who can afford a potentially higher interest rate or for people who are planning to keep the home for a limited period of time, such as those financing a short-term purchase like a starter home or an investment home they’re planning to flip.

You’ll likely save money with the lower teaser interest rate during the fixed period, which means you may be able to put more toward savings or other financial goals. If you sell the home or refinance before the adjustable period begins, you could save more money in total interest paid than you would with mortgages with fixed interest rates.

The risks of ARMs

One of the biggest drawbacks of an ARM is that the interest rate is not locked in past the initial fixed period. While it may initially work out in your favor if interest rates start low, an increase in rates could raise your monthly mortgage payment. That could put a big dent in your budget — or leave you facing payment amounts you can no longer afford.

You’ll also want to carefully weigh the risks of an interest-only ARM. Not only can interest rates rise, causing a potential for higher payments when the interest-only period ends, but without money going towards principal your equity growth is reliant on market factors.

You shouldn’t consider an ARM if the only reason is to purchase a more expensive home. When determining affordability of an ARM, always plan with the worst-case scenario as if the rate has already begun to adjust.

Understanding fixed-rate mortgages

These loans can be easier to understand: For the life of the loan (typically 15, 20 or 30 years), your monthly interest rate and principal payments remain the same. You don’t have to worry about potentially higher interest rates, and if rates drop, you may have the opportunity to refinance — paying off your old loan with a new one at a lower rate.

The benefits of fixed-rate mortgages

These loans offer predictability. By locking in your rate, you don’t have to worry about fluctuating market conditions or hikes in interest rates, which can make it easier for you to manage your budget and plan for other financial goals.

If you’re planning to stay in the home long term, you could save money over time with a consistent interest rate, especially for those with good credit who may be able to qualify for a lower interest rate. This is one reason fixed-rate mortgages are popular among homebuyers. According to Freddie Mac, nearly 90% of homeowners opt for a 30-year fixed-rate mortgage.

The risks of fixed-rate mortgages

While many homebuyers want the stability of monthly mortgage payments that don’t change over time, the lack of flexibility could possibly cost you. If interest rates drop significantly, you’ll still be paying the higher fixed interest rate. To take advantage of lower rates, you’d have to refinance — which could mean you’d be paying expenses like closing costs all over again.

Adjustable-rate mortgages vs. fixed: Which is right for you?

Choosing the right loan is based on your personal situation. As you weigh your options, asking yourself these questions might help:

• How long do I plan to own this home? If you know this isn’t your forever home or one you plan to live in for an extended period, an ARM might make sense so you can save money on interest.
• If I go with an ARM, how much could my payments change? Check the caps on your interest rate increases, then do the math to determine how much your mortgage payment would be if your interest rate rose to that level. Would you be able to still afford the payments?
• What is my budget like now? If your current monthly budget is tight, you might want to take advantage of the potential savings offered by an adjustable-rate loan. But if you’re worried that even a small interest rate increase would mean financial stress for you and your family, a fixed-rate mortgage might be better for you.
• What is the prediction for future interest trends? No one can predict what will happen, but certain economic signs could indicate whether an interest rate hike is coming. Are you comfortable with the uncertainty, or would you prefer the steady payment amounts of a fixed-rate mortgage?

Example Scenario

There’s no shortage of online tools that can help you compare the costs of an ARM versus a fixed mortgage. That said, there’s also no shortage of scenarios you could run with a calculator Opens in a New Window.‍ ‍ ^{See note 1} Let’s look at an example using basic terms, while not taking into consideration some of the additional factors like closing costs, taxes and insurance.

Sally finds a home with a purchase price of $400,000 and she has saved up to make a 20% down payment and plans to stay in the home for seven years. In this scenario, let’s assume that Sally believes interest rates will only rise. The terms of the two loans are as follows:

Fixed-rate mortgage

• 30-year term
• 5% interest rate
  

Adjustable-rate mortgage

• 30-year term
• 3.5% initial rate
• 5/1 adjustment terms
• 1% annual adjustment cap
• 3% minimum rate
• 8.5% lifetime cap
• 2.75% margin
• 1.25% index rate
• 6 months between index adjustment
• 0.25% index rate change between index adjustments

In running the calculations over the seven years, a fixed mortgage would have a total cost of $105,722. In comparison, the total cost of an ARM would be $81,326, which is a savings of $24,396 during that period.

Now let’s assume all the above terms stay the same, except Sally stays in the home for 20 years. Over that time, the total costs of the fixed mortgage would be $245,808, while the ARM would be $317,978. That’s a $79,720 savings over 20 years with the fixed mortgage.

There’s a lot to consider, and while adjustable-rate mortgages may not be very popular, they do have some advantages that are worth considering. It’s important to weigh the pros and cons and consider speaking with a professional to help solidify your choice.