ARM vs. Fixed-Rate Mortgage: Differences and How to Choose
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Many home buyers choose a fixed-rate mortgage, but home loans aren't one-size-fits-all. An adjustable-rate mortgage, or ARM, might be worth considering. ARMs tend to start out with lower interest rates — and lower monthly payments — than comparable fixed-rate loans.
Comparing ARM and fixed-rate mortgages will help you choose the home loan that matches your needs and goals.
How a fixed-rate mortgage works
Fixed-rate mortgages have interest rates that stay the same through the life of the loan. The monthly principal and interest stay the same, although payments can fluctuate when the costs of property taxes and insurance change. Most mortgages are fixed-rate loans.
How an adjustable-rate mortgage works
An adjustable-rate mortgage begins with a set interest rate for a specified number of years. After that, the rate is adjusted periodically according to broad market conditions. An ARM's rate is adjusted at regular intervals until the end of the loan term, which is typically 30 years.
The length of an ARM's fixed-rate period is in the name. A 5-year ARM's initial rate will be fixed for five years. The most common ARM terms have initial fixed-rate periods of three, five, seven or 10 years.
After that initial fixed-rate period, most ARMs have rate adjustments every six months. You might find ARMs described as 5/6 or 7/6. The number before the slash refers to how many years the initial rate will be fixed, and the number after the slash refers to the number of months between rate adjustments after the fixed-rate period has expired.
Although ARM interest rates start lower than fixed-rate loan rates, there’s a chance they will reset higher, increasing your mortgage payment. Fortunately, ARMs have caps that limit how much the interest rate can change the first time it's adjusted, in subsequent adjustments and over the lifetime of the loan.
Example: ARM vs. fixed-rate mortgage payments
5-year ARM | 30-year fixed rate mortgage |
|---|---|
Mortgage amount: $400,000 | Mortgage amount: $400,000 |
Interest rate: 6.5% | Interest rate: 7% |
Payment: $2,528 (after five years, this payment will reset using a new interest rate that could increase it) | Payment: $2,661 (this payment will never change as long as you have the same mortgage) |
Who an ARM is for
If this isn't your forever home, and you'll move in several years, an ARM could be a good choice. You'll get the benefit of a lower introductory rate and payments in the first years of homeownership. Then ideally you'll sell before the fixed-rate period ends.
It's possible that the rate and payments could decrease after the initial fixed-rate period ends. But it's also possible that the rate and payments could increase.
You can refinance an ARM into a fixed-rate loan or another ARM. You might choose this option if you keep the home longer than expected, and you want the stability of a fixed interest rate.
Who a fixed-rate mortgage is for
A 15- or 30-year fixed-rate mortgage may be right for you if you plan to own the home for the long haul. A fixed-rate mortgage has the advantage of stable, predictable monthly payments because the interest rate can't go up. And if rates drop a few years into your mortgage, you may be able to refinance your mortgage into another fixed-rate loan at a lower rate.
Fixed-rate mortgages are simpler than ARMs, which can make comparing lender offerings easier.
How to decide whether to get an ARM or fixed-rate loan
Is an ARM or a fixed-rate loan better? To choose between them:
Think about how long you plan to own the home. An ARM might be worth it if you'll sell the home or pay off the mortgage in 10 years or less. But a fixed-rate mortgage would probably work better if this will be your forever home and you want the certainty of a stable interest rate and monthly payment.
If you're considering an ARM, check the caps on how much the interest rate can increase. Then calculate how much your mortgage payment would be if rates rose to those levels. Would you be able to afford the payments? If not, shop for a fixed-rate mortgage.
Whether you choose an ARM or a fixed-rate mortgage, shop around and get preapproved with at least three lenders to compare offers.
» MORE FOR CANADIAN READERS: Fixed vs. variable mortgages
