Fixed-rate mortgages are a popular choice for home loan financing because they feature predictable housing payments over a long period of time. But ARMs offer lower payments in the first years, making them a valid option for those who plan on selling or refinancing in the near future. ARM mortgage rates can adjust upward and downward as economic conditions change, which is an advantage when rates are falling and a drawback when they rise.
If you’re planning to buy a home in the near future, it’s important to explore the pros and cons of fixed- and adjustable-rate mortgages to determine which one is a better fit for you.
[Read: Best Mortgage Lenders]
How a Fixed-Rate Mortgage Works
A fixed-rate mortgage offers an interest rate that remains the same throughout the life of the loan. This means that your monthly principal and interest payment won’t change. Because fixed-rate mortgages provide more certainty than ARMs, they’re much more popular among homebuyers, especially when interest rates are low.
Understand that while your loan’s principal and interest payment is fixed for the duration of the loan, your overall monthly payment can still fluctuate due to homeowners insurance premiums and property taxes, which typically tend to rise over time.
How an Adjustable-Rate Mortgage Works
ARMs typically have a lower, fixed interest rate for an introductory period, which can range from three to 10 years. ARM rates are lower than fixed rates; this is the benefit for borrowers willing to take on more risk.
Once the fixed period is over, though, your rate begins to adjust at regular intervals based on market conditions. When you shop around for ARMs, you’ll typically see figures like 5/1 or 7/6. The first number refers to the number of years that the interest rate will be fixed, and the second number refers to how often the rate changes after that.
If the second number is 1, your rate can adjust every year. If it’s 6, your rate may change every six months.
Keep in mind that there are limits to how much your interest rate can change. Here’s some of the terminology you may come across as you compare ARM options:
— Initial cap. This is the maximum amount that an interest rate can increase the first time it adjusts after the fixed period ends.
— Periodic cap. This limits increases for each adjustment after the first one. It may or may not be the same as the initial cap.
— Lifetime cap or ceiling. The lender cannot increase your interest rate beyond the lifetime cap or ceiling.
— Floor. The lender cannot decrease your interest rate below the loan’s floor.
— Index. A published financial economic measurement, like the Treasury Index, that lenders use to calculate your interest rate adjustments.
— Margin. This is a percentage that the lender adds to the index to determine your rate.
— Fully-indexed rate. This is your loan’s rate once it begins adjusting. It equals the loan margin plus its index. This rate is subject to the ARM’s caps and floors.
ARMs are relatively uncommon — as of the first quarter of 2024, only 3.5% of mortgages in the U.S. have an adjustable rate, according to the Federal Housing Finance Agency. However, they become more popular as interest rates rise, and ARMs had nearly 20% market share in April 2023 according to CoreLogic.
Key Differences Between Fixed- and Adjustable-Rate Mortgages
As you compare adjustable- vs. fixed-rate mortgages, it’s important to understand how their differences can impact you and your budget. Here’s a quick look at some of these differences to help you determine which is a better fit for you:
| Fixed-Rate Mortgage | Adjustable-Rate Mortgage |
| Rate stays fixed for the life of the loan. | Rate stays fixed for a period then adjusts regularly. |
| Rate won’t increase if market rates go up. | Rate will increase if market rates go up. |
| Rate won’t decrease if market rates go down. | Rate will decrease if market rates go down. |
| Starts out higher than ARM rate. | Starts out lower than fixed rate. |
| Offers long-term predictability with payments. | Offers short-term predictability with payments. |
[Read: Best Adjustable-Rate Mortgage Lenders.]
Who Should Consider a Fixed-Rate Mortgage?
If you’re considering a fixed vs. ARM loan, here are some situations where it makes more sense to choose the fixed option:
— You’re planning to stay for a long time. If you’re buying your forever home, getting an interest rate that won’t change is likely the better choice. You don’t have to worry about changes to your budget, and you can rest easy with more predictable payments.
— Mortgage rates are low. When market rates for mortgages are lower than usual, it may make sense to lock in a fixed interest rate, even if you’re not entirely sure how long you plan to stay in your home. At that point, rising interest rates may not be a matter of “if” but “when.”
— You don’t want to take on any risk. With an adjustable-rate mortgage, it’s the borrower who takes on the risk of interest rates going up. So even if you expect to sell your home before the ARM’s fixed period expires, you may feel more comfortable with a fixed rate and let the lender assume more risk.
— You want a simpler loan. ARMs are more complicated, and those complexities can be stressful for borrowers who aren’t well-versed in how ARMs work. If you want a simpler loan, a fixed-rate mortgage may be better. “Because the rate and payments are fixed, the costs are known upfront, and it makes budgeting easier,” says Tassone.
Who Should Choose an Adjustable-Rate Mortgage?
As you consider the fixed-rate mortgage vs. adjustable-rate mortgage debate, here are some reasons you might want to choose an ARM:
— You plan to move soon. “If you are sure you will move, refinance or pay off your mortgage before the fixed period of an ARM ends, it might be the better choice,” says Brendan Phillips, head of underwriting at Findigs, a rental screening platform. “Otherwise you’re taking a gamble with banks on the direction of mortgage rates.” Even if you move a year or two after your fixed period expires, the savings you enjoyed during that time could still outweigh the cost of an increased rate for a short time.
— You’re on a budget. Even if you’re not sure about when you plan to sell your home, an ARM offers a lower monthly payment during the fixed period. If you end up staying in your home longer than you initially thought, you can still refinance to a fixed-rate mortgage to avoid rate fluctuations. There will be some costs associated with the refinance, but it can be worth it.
— Mortgage rates are high. If mortgage interest rates are relatively high when you buy a house, an ARM could provide a better interest rate over time, especially if rates fall in the future. You’d pay a lower introductory rate and continue to save as long as rates remain stable. And if they fall, you’d benefit without the hassle and expense of refinancing.
If you’re seriously considering an ARM, Phillips recommends getting as many details about the arrangement upfront. “Be sure to ask your lender questions like, ‘When is the soonest my rate could go up?’ ‘What are the caps on my rate changes?’ ‘How high could my rate increase?’ and more before applying for a loan,” he says.
[Read: Best Mortgage Refinance Lenders.]
Choosing the Right Mortgage for You
As you search for a mortgage to help you buy your next home, think carefully about your situation and goals. There’s no one-size-fits-all solution, so it’s important to know which is best for you and your budget.
Consider speaking with a financial advisor or mortgage professional who can give you some objective and expert advice on the matter.
Also, make sure you consider the various loan programs that are available. While ARMs are plentiful among conventional mortgage lenders, they may not be as common with certain government-backed loan programs — for example, the U.S. Department of Agriculture does not insure loans with adjustable rates as part of its rural loan program.
With the right approach and research, you’ll have an easier time picking the mortgage option that works best for you.
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Fixed- or Adjustable-Rate Mortgage: Which Is Better? originally appeared on usnews.com
Update 09/12/24: The story was previously published at an earlier date and has been updated with new information.
