Getting a mortgage means choosing between an adjustable-rate mortgage (ARM) and a fixed-rate loan. The choice you make will have a significant effect on your borrowing cost and on your cash flow for years to come, so it’s critical to weigh the pros and cons.
What's the Difference Between ARMs and Fixed-Rate Mortgages?
|Fixed-Rate Mortgages||Adjustable-Rate Mortgages|
|Begin with a higher interest rate, but payments could be lower than for an ARM in the later years of the loan term||Payments and the interest rate can be lower than with fixed-rate mortgages in the early years|
|Payments will remain the same throughout the life of the loan||Payments could potentially rise and even become unaffordable, depending on the economy|
Choosing between an ARM and a fixed-rate mortgage comes down to weighing their unique features. ARMs typically have lower initial monthly payments in the beginning, but these payments can change. They could become unaffordable if they rise significantly. Fixed-rate mortgages start with a higher rate, but the interest rate and monthly payment don’t change over the life of the loan.
Fixed-rate mortgages are safe and predictable. You'll know how much you’ll pay every month for entire term of your loan. But your interest rate is typically higher than the starting rate on an ARM, so your monthly payment is also higher, at least in the early years.
Fixed-rate loans keep the same interest rate throughout the life of the loan. You'll also keep the same monthly payment as a result. There won't be any surprises, no matter what interest rates or the economy do while you're paying down your mortgage.
You'll pay a price for this predictability, however. Fixed-rate loans typically start with a slightly higher interest rate than ARMs.
Adjustable-Rate Mortgages (ARMs)
Nobody knows precisely what will happen with interest rates. It’s hard to predict the timing and the speed of interest rate changes even if you correctly guess which direction they'll move (higher or lower). Adjustable-rate mortgages allow you to share the risk of that uncertainty with your lender. You pay less in return—at least in the early years. 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. But ARMs feature an interest rate that can change as rates and the economy change. Your rate may decrease if interest rates fall, but your monthly payment will increase if they rise.
You might not be able to afford your required monthly payments if interest rates rise, or you could end up paying more interest over the life of the loan than you would have paid if you had taken a fixed-rate mortgage.
Your rate may be fixed for one year, three years, five years, seven years, or even longer, but changes are possible after that point. The rate is fixed for five years (the first number listed) and can change annually after that (the second number shown) if you have a 5/1 ARM.
Lenders typically base your rate on a popular benchmark such as LIBOR. As that rate moves, your loan follows. In most cases, your rate is the benchmark rate plus a spread (an additional amount on top of the benchmark). For example, your interest rate would adjust to 2.75% if LIBOR is at 2.5% and the spread on your loan is 2.25%.
LIBOR starts phasing out at the end of 2021, but another benchmark will be used.
Rates might not change as much as the underlying benchmark if your loan has caps. You’d only experience an increase of 2% in your interest rate if your loan has a cap of 2%, but the index increases by 3%. Loans can use initial caps for the first few years, or they might use periodic caps (for each yearly adjustment), and lifetime maximums.
Which Is Right for You?
Evaluate your needs and pick the loan that best meets them. A fixed-rate loan is the safer choice if you have a tight budget and if any increases in your mortgage payment might be difficult to handle. You'll pay more than an initial ARM payment, but you'll never be caught by surprise, wondering where you're going to come up with the extra money.
It may also make sense lock in a low rate with a fixed-rate loan if you believe rates are likely to steadily rise in the coming years.
But you can use an ARM’s relatively low monthly payment to prepay your mortgage and reduce your loan balance more quickly unless there’s a sharp increase in interest rates. Significant prepayments might manage the risk of an increase in future interest rates because the rate won't matter as much with a smaller loan balance. An ARM allows your rate to drop without the need to refinance if rates fall.
ARMs become more attractive if you don't think you'll be living in the property or paying on the property for decades. You might be comfortable using an ARM that adjusts after five or seven years if you're only planning to keep your loan for six years.
Fixed-Rate Mortgage vs. ARM Example
The Bottom Line
Interest rates can rise or fall, so it’s critical to understand the potential risk of using an ARM. The lower payment might be appealing, but the strategy can backfire if interest rates rise substantially.