Comparing fixed-rate and adjustable-rate mortgages
Most home shoppers choose fixed-rate mortgages without much thought about adjustable-rate mortgages.
But you may be surprised to learn both types of mortgages have advantages.
Depending on your situation, an adjustable-rate mortgage (ARM) could lower costs.
Let’s look closely at each type of loan to see which one works best for you.
Fixed-rate mortgages are the most popular mortgage loan. Over 90% of home buyers will pick a fixed–rate loan over an ARM loan.
The Federal Housing Administration (FHA) created fixed-rate mortgages to make homes easier to buy. Now, all of the major home loan programs offer fixed rates.
With a fixed rate, your mortgage principal and interest payments won’t increase during the life of the loan. This predictability means you can budget your money more easily for years to come.
Most borrowers today like the combination of a low rate plus stability that a fixed mortgage provides. And with rates still near historic lows, mortgage shoppers can’t go wrong by locking in a fixed rate.
So why do variable rate loans still exist? Because some homebuyers can create more room in their budget by choosing an ARM whose introductory rate can be even lower than a 30-year fixed rate.
Adjustable-rate mortgages work differently than fixed-rate mortgages in a number of ways.
An ARM has a fixed introductory rate for a pre-set number of years. After this introductory period ends, the loan’s rate begins to adjust along with changes in overall mortgage rates. This is still a 30 year mortgage but one where you’ll pay a fixed rate for the first 5 years (or 7 or 10 years, depending your loan’s structure). For the remaining period of the loan (23, 25 or 20 years) you’ll pay a rate that can adjust as often as once per year.
As your rate changes, so will your monthly mortgage payment.
Introductory rates on ARMs, on average, are lower than fixed rates, so an ARM’s initial mortgage rate tends to be easier on budgets. An ARM’s introductory period could last five or seven years, for example, which would mean lower monthly payments during this period.
Then, if you sold or refinanced your home before the intro ARM rate expired, you’d be finished with the loan before its first rate increase.
How does an ARM work? Reading the numbers
When you’re considering an adjustable-rate mortgage, be sure to learn all of the loan’s details so you’re not surprised by a rate change.
Most importantly, you’ll want to know how long the initial interest rate will last before the rate adjustments begin.
An ARM will tell you this detail in its series of numbers. In a 5/1 ARM, for example, the first number tells you the length of the loan’s introductory period. In this case, you’d have a fixed interest rate for five years before the rate increases or decreases.
The second number shows how often the loan’s rate can change. In a 5/1 ARM, your rate could change each year after the five-year introductory period expires.
Rate caps limit how much your ARM can change
An ARM has another important series of numbers that set limits on how much your loan rate can change. This series of numbers shows your rate caps.
For example, if you have an ARM with a 2/2/5 cap, your rate cannot change by more than:
- 2% after the fixed-rate period ends
- 2% for each adjustment period
- 5% over the life of the loan
So, with a 2/2/5 cap on a 5/1 ARM with an introductory interest rate of 3%, your loan’s rate:
- Would remain at 3% for the five-year introductory period
- Could reach as high as 5% after the intro rate expires
- Could increase by up to 2% at each subsequent yearly adjustment
- Could never surpass 8% during the life of the loan
These lifetime caps on ARMs protect borrowers from out-of-control rate increases, but even a 5% rate increase would mean much higher monthly payments.
You’d want to refinance out of your ARM before its intro rate expires, especially during a high-rate environment.
Fixed rate or adjustable rate: Which loan is right for you?
If you’re like most homebuyers, you’ll want the predictability of a fixed interest rate.
After all, with a fixed rate on a 30-year mortgage, the payment on your principal and interest won’t change for three decades. (Your property taxes and homeowners insurance will likely change your monthly payment some.)
So how will you know if an ARM could save you money? Answering these questions can help:
How large a mortgage payment can you afford?
An ARM’s lower introductory rate could help you afford a more expensive home, or it could make more room in your monthly budget for several years or more.
But you’ll need to be ready to refinance or sell the home before the ARM’s introductory period ends, especially if interest rates are higher at that time.
How long do you plan on staying in the home?
When you’ll stay in your new home for only a few years, an ARM can help you save money during that period. After all, you’d be selling the home and paying off your loan before interest rates change.
If you change your plans and decide to stay in the home, you could still refinance before the ARM’s rate adjustments start to increase your payment.
What are interest rates like?
During the COVID-19 pandemic, lenders have been offering historically low interest rates, offering homebuyers an opportunity to lock in uncommon savings with a fixed rate.
When market conditions change and mortgage rates increase, ARMs will likely be more attractive.
How frequently does the ARM adjust?
An ARM’s initial interest rate will stay the same for a period of time — usually three, five, or seven years. After that, most ARMs adjust their rate every year to reflect market conditions.
Make sure your ARM’s introductory period lasts long enough to create the savings you’re aiming for. Remember that refinancing your mortgage loan requires closing costs, so you’ll have to pay to exit your ARM.
Could you afford your monthly payments if interest rates significantly increase?
Nobody can predict the future of mortgage rates. Who would have guessed in the summer of 2019 that rates would be so low going into 2022?
If there’s no way you could afford your mortgage payment with a higher interest rate that falls within your ARM’s rate caps, be careful. If your plans to sell or refinance before the introductory rate expires fell through, your personal finances could suffer.
Fixed rate and ARM pros and cons
Both types of mortgage loans have their pros and cons.
|Predictability & simplicity||Higher rates than initial interest rate of an ARM|
|Long-term savings during low rate environments||Higher monthly payments, especially on 15-year fixed-rate loans|
|Creates short-term savings||Complexity|
|Works well for temporary homes||Payments could change a lot after intro rate expires|
|Good for investors or “house flippers”||Makes budgeting your money more difficult|
ARM vocabulary: Knowing the terms
Adjustable-rate loans intimidate some homebuyers because of their terminology. If you’re considering an ARM, you should know these terms:
- Adjustment frequency: The amount of time between rate adjustments once the introductory period expires. The adjustment frequency for most ARMs is one year
- Adjustment indexes: An ARM’s rate won’t change randomly. Instead, it will be tied to an index rate. Many ARMs are tied to the SOFR (Secured Overnight Financing Rate)
- Margin: The gap between your loan’s index rate and your loan’s actual rate. A margin of 2% means your rate will be 2 percentage points higher than your loan’s index rate
- Caps: Limits on how much your rate can change during one adjustment period or over the entire term of the loan
- Ceiling: The highest possible rate you could be paying during the life of the loan
- Annual cap: The most your interest rate can increase during an annual adjustment period
- Lifetime cap: A limit on how much your rate could increase during the entire life of the loan
Always be sure to ask your loan officer when you’re not quite sure how your loan will work.
Other ways to lower your mortgage rate besides getting an ARM
Some loan shoppers consider an adjustable-rate mortgage only because of its lower interest rate. Here are some ways to score a lower rate on a fixed-rate loan:
- Shop around: Each lender will see your application a little differently. Getting Loan Estimates from at least three lenders increases your chance of finding a lower fixed rate
- Improve your credit score: With any kind of mortgage loan, a better credit score can lower your rate. Credit reporting errors could be pulling down your score. Missing payments will pull down your score, too
- Increase your down payment: Exceeding your loan’s minimum down payment could put your lender at ease and lead to a lower mortgage rate
- Pay off some debt first: Lenders prefer a lower debt-to-income ratio, or DTI, so you could trim your rate by paying off a student loan or getting your credit cards under control
- Choose a shorter loan term: Average rates on 15-year fixed loans are lower than average rates on 30-year fixed-rate loans. But a 15-year term requires higher monthly payments than a 30-year term
Combining several of these strategies could help lower your fixed rate so you could afford your loan without accepting the uncertainty of an ARM.
Fixed- vs adjustable-rate mortgage FAQs
What’s the difference between a fixed-rate and adjustable-rate mortgage?
A fixed-rate loan’s interest rate won’t change, and its loan payments will remain the same throughout the life of the loan. An adjustable-rate mortgage begins with a fixed rate but then the rate changes periodically based on market conditions. As a result, payment amounts on an ARM will change periodically.
What are two disadvantages to an adjustable-rate mortgage?
Adjustable-rate mortgages are not as predictable as fixed-rate loans since their monthly payments will eventually change. Also, ARMs are more complicated than fixed-rate loans.
Why would a home buyer choose an adjustable-rate mortgage?
On average, ARMs offer lower mortgage interest rates during the introductory period which can last for several years. This lower rate gives homebuyers a chance to save money, especially if they sell or refinance the home before the ARM’s fixed period expires.
Is it better to go with a fixed or variable mortgage?
For most borrowers, especially first-time homebuyers, the simplicity of a fixed-rate mortgage works best. But in some cases, borrowers can enjoy lower payments with an ARM and then refinance or sell the home before the loan’s rate adjustments begin.
Why is an adjustment rate mortgage a bad idea?
Buying a home with an ARM would be a bad idea if:
- You didn’t refinance or sell the home before the loan’s fixed period expired, and
- Mortgage interest rates were a lot higher when the fixed period ended
This combination could increase your monthly payment significantly. It could make your home unaffordable.
How are ARMs and fixed-rate mortgages similar?
Both ARMs and fixed-rate mortgages begin with a fixed rate and level monthly payments. But a fixed loan’s initial interest rate lasts throughout the term of the loan while an ARM’s rate will begin to change, usually in three, five, or seven years.
Current mortgage rates
Mortgage interest rates rise and fall daily, but they continue to trend near historic lows. This has made home buying and refinancing incredibly affordable.
If you’re looking for a short-term loan, an ARM’s lower introductory rate could help you save even more.
Before applying for a home loan, be sure to check current rates for fixed- and adjustable-rate mortgages.