Differences Between ARM and Fixed Rate Mortgages
When you get a mortgage, you need to choose between adjustable-rate mortgages (ARMs) and fixed-rate loans. The choice you make could have a significant effect on your borrowing cost, so it’s critical to weigh the pros and cons.
Choosing between an ARM vs. a fixed-rate mortgage comes down to these essential features:
- ARMs typically have lower initial monthly payments. But the payments can change, and if they rise, they may become unaffordable.
- Fixed-rate mortgages start with a higher rate, but the interest rate and monthly payment don’t change over the life of the loan.
Let’s explore how these loans work and how to determine which is best for you.
Fixed-Rate Mortgages: Easy to Understand
It’s easiest to start with standard fixed-rate loans, and then examine how adjustable loans work differently.
- Pros: Fixed-rate mortgages are safe. You know how much you’ll pay, and you don’t risk payment-shock.
- Potential cons: Your rate is typically higher than the starting rate on an ARM, so your monthly payment is also higher. If rates never change (or if they drop), you pay more with a fixed-rate loan.
Predictability: Fixed-rate loans keep the same interest rate through the life of the loan. As a result, you also keep the same monthly payment (see how to calculate payments for more details). If you know you can afford the payment on a fixed rate loan, there will be no surprises, no matter what interest rates do.
Interest rate: You pay a price for that predictability. ARMs start with a slightly lower rate than a fixed-rate loan, all other things being equal. Using rates from the Mortgage Bankers Association (MBA), the starting rate for a 5-year ARM was 4 percent, versus 4.81 percent for average 30-year fixed-rate mortgages and 4.25 percent for 15-year loans.
ARMs: Share Risk With Your Lender
Nobody knows precisely what will happen with interest rates. Even if you correctly guess which direction rates will move (higher or lower), it’s hard to predict the timing and the speed of interest rate changes. ARMs allow you to share the risk of that uncertainty with your lender. In return, you pay less—at least in the early years.
- Pros: ARMs typically start out with a lower interest rate than fixed-rate loans. A lower rate results in a lower monthly payment, making cash flow more manageable. If rates fall, your rate may even decrease.
- Potential cons: If interest rates rise, your monthly payment may increase. If that happens, you might not be able to afford your required payments, or you may end up paying more overall than you would have paid with a fixed-rate mortgage.
- A rate that changes: ARMs feature an interest rate that can change as rates in the economy change.
- When rates change: Your rate may be fixed for one year, three years, five years, seven years, or more. After that, changes are possible. For example, with a 5/1 ARM, the rate is fixed for five years (the first number listed) and can change annually (the second number) after that.
- How much? Lenders typically base your rate on a popular benchmark like LIBOR. As that rate moves, your loan follows. In most cases, your rate is the benchmark rate plus a spread (or an additional amount on top of the benchmark). If LIBOR is currently 2.5 percent and the spread on your loan is 2.25 percent, your new interest rate would adjust to 2.75 percent.
- Caps limit adjustments: Rates might not change as much as the underlying benchmark if your loan has caps. For example, if your loan has a cap of 2 percent, but the index increases by 3 percent, you’d only experience an increase of 2 percent in your interest rate. Loans can use initial caps for the first few years, periodic caps (for each yearly adjustment), and lifetime maximums.
ARM vs. Fixed-Rate: Which Is Best?
Evaluate your needs and pick the loan that fits your needs best. Both types of loans have pros and cons, but depending on your situation, the choice may be clear.
Need for certainty: If you have a tight budget and any changes would be disastrous, a fixed-rate loan is a safer choice. Although you pay more than an initial ARM payment, you won’t be caught by surprise.
Interest rate predictions: Again, it’s hard to predict the direction, timing, and speed of rate movements (but you might guess one or two of those three correctly). That said, if you believe rates are low and they’re likely to rise, it may make sense lock in a low rate with a fixed-rate loan. If rates are high and set to fall, an ARM allows your rate to drop without the need to refinance.
Aggressive prepayment: Unless there’s a sharp increase in interest rates, you can use an ARM’s relatively low monthly payment to prepay your mortgage and reduce your loan balance. Significant prepayments might manage the risk of an increase in future interest rate—with a smaller loan balance, the rate might not matter as much.
How long will you borrow? A short timeframe can also make ARMs more attractive. For example, if you know that you’ll only keep your loan for six years, you might be comfortable using an ARM that adjusts after five or seven years.
Fixed-Rate Mortgage vs. ARM Example
Rates can rise or fall, but it’s critical to understand the potential risk of using an ARM. The lower payment is appealing, but the strategy can backfire if rates rise enough.
Assume you borrow $200,000, and you’re choosing between a 5/1 ARM or a 30-year fixed-rate mortgage. In this example, we assume that rates rise, and your ARM rate increases by 2 percent at your first adjustment (in Year 5). Rates continue to rise 1 percent per year for the next two years.