So, you’re considering purchasing a home? There’s a lot to think about—there’s lots of mortgage buzzwords and industry lingo to decipher. It can all be very overwhelming, especially for first-time home buyers.
One of the main decisions you need to make regarding your mortgage is selecting a fixed-rate or an adjustable-rate mortgage. Fixed-rate mortgages charge the same fixed interest rate for the duration of the loan. Adjustable-rate mortgages, on the other hand, have rates that fluctuate over time.
It’s important to understand how each type of mortgage works and how interest rates can impact your mortgage payments. Keep reading to learn more.
- Interest rates for fixed-rate mortgages remain constant over the life of the loan.
- ARM mortgages start with a lower fixed-rate period before switching to variable rates that are assessed regularly.
- Deciding if an ARM or fixed-rate mortgage is right for you depends on your specific situation.
In This Piece
- How Adjustable-Rate Mortgages (ARM) Work
- How Fixed-Rate Mortgages Work
- ARM vs. Fixed-Rate Mortgage: Example Mortgage Payments
- Is an ARM or Fixed Rate Mortgage Better?
- Tips for Choosing
- Understand Your Options
How Adjustable-Rate Mortgages (ARM) Work
Interest rates with an adjustable-rate mortgage, also referred to as an ARM, are variable—meaning they can change over time. Typically, ARMs start with a fixed-rate period, such as one, three, five, seven, or 10 years. After this initial period, interest rates adjust annually based on the current index. Your mortgage agreement details these terms.
When shopping for an ARM, you’ll notice that many types are listed as a ratio, such as 1/1, 3/1, 5/1, 7/1, 10/1 and more. The first number represents the number of years the mortgage will remain at the fixed-rate amount. In the example above, this would be one, three, five, seven, or 10 years.
The second number indicates how often the rates are adjusted after the initial fixed-rate phase is over. In most cases, this number is one, to represent one year. This means that rates are adjusted annually for most adjustable-rate loans.
Fortunately, many ARM agreements also include a cap for interest rates. For instance, one of the most common types of ARM is 5/1 with a 2/6 cap. This notation means the mortgage has a five-year fixed-rate period, after which the rates will reset every year. Interest rates, however, can’t increase more than 2% in any given year and not more than 6% in total over the life of the mortgage.
During the initial fixed-rate period of your mortgage, your monthly payments remain exactly the same. However, once this period is over, your monthly mortgage payments are likely to change from year to year depending on interest rates.
How Fixed-Rate Mortgages Work
Unlike an adjustable-rate mortgage, interest rates with a fixed-rate mortgage remain constant throughout the life of the mortgage. One of the best benefits of a fixed-rate mortgage is that your monthly payments remain exactly the same until the loan is paid in full. However, the amount of principal paid each month may fluctuate.
A disadvantage of fixed-rate mortgages is the potential for interest rates to decrease dramatically over the course of the loan. However, you can choose to refinance your mortgage, if you qualify, to take advantage of these lower rates.
ARM vs. Fixed-Rate Mortgage: Example Mortgage Payments
The table below can help you better understand the difference between mortgage payments for ARMs and fixed-rate loans.
|Type of loan||5/1 ARM||30-year Fixed-Rate Loan|
|Monthly payments||$2,623.71 per month during the initial five-year fixed-rate period (payments will adjust annually thereafter)||$2,840.81|
As you can see, initial interest rates are typically much lower for ARMs than for fixed-rate loans. However, after this initial phase, these rates can increase, which will also increase monthly payments. Use our convenient mortgage calculator to determine how much you can expect your monthly payments to be per month for an ARM and a fixed-rate mortgage.
Is an ARM or Fixed-Rate Mortgage Better?
There are advantages and disadvantages to both adjustable-rate and fixed-rate mortgages. For example, fixed-rate mortgages are easier to budget because monthly payments remain the same throughout the life of the mortgage. This can be a huge advantage for homeowners who are concerned about increasing rates.
However, if interest rates decline over the course of your loan, you’ll be stuck paying a higher amount. It may be possible to refinance your mortgage to take advantage of these lower rates. However, you must still have the right credit score to buy a home.
On the other hand, a great advantage of ARMs is that they typically offer lower initial interest rates. Oftentimes, homeowners have lower monthly payments during this initial phase vs. those opting for fixed-rate loans. The disadvantage is that interest rates could spike during the fixed-rate phase. If this happens, homeowners could face significantly higher mortgage payments at the end of the initial fixed-rate period.
Why Would You Choose an Adjustable Rate Over a Fixed Rate?
Adjustable-rate mortgages are an attractive offer for many first-time home buyers. First, they offer lower interest rates for the first several years, which results in lower monthly payments. Secondly, many first-time home buyers only plan to stay in their homes for several years before upgrading to larger houses.
In these cases, an ARM loan can be an ideal option because they’re likely to move before the end of the fixed-rate phase or soon after. This option allows them to enjoy lower interest rates until they’re ready to upgrade.
Tips for Choosing
Ultimately, selecting an ARM or a fixed-rate mortgage is a personal decision that depends on your specific situation. However, if you’re trying to choose between these two options, here are some factors to consider.
How Long Will You Be in the Home?
The first thing you want to consider is how long you plan to stay in your new home. If your plans are to remain in the home for only several years, an ARM may be the best option. For instance, if you plan to stay in your home for less than seven years, a 7/1 ARM will allow you to take advantage of lower interest rates until you sell the home.
If, on the other hand, this is your forever home, and you have no plans on moving in the near future, a fixed-rate mortgage that offers consistent monthly payments may be the better option.
How Frequently Does the ARM Adjust?
You also want to check the details of the loan and determine how often ARM rates will adjust. For example, a 7/1 ARM offers 7 years of ARM rates at the fixed rate, then the interest rates readjust every year afterward. Rates on a 7/6 ARM will readjust every six months. If this is too much fluctuation for your budget, you may want to consider a fixed-rate mortgage.
What Are Interest Rates Like?
Another thing you want to consider is the current state of interest rates and predictions for future increases or decreases. When interest rates are low, investing in a fixed-rate mortgage can help you lock in these lower rates. Alternatively, when interest rates are high or rising, it may make more sense to select an ARM, with hopes that these rates will come back down before the initial fixed-rate period ends.
How Much Can You Afford Now?
ARMs typically offer lower monthly payments during the first few years. This can be an attractive option for those just beginning their careers and planning to increase their earnings in the future. An adjustable-rate mortgage allows you to take advantage of lower monthly payments now and risk possible higher payments when you have more wealth.
Can You Afford a Payment Increase?
It’s important to recognize that as interest rates with an ARM adjust, so will your monthly payments. Make sure you can budget these shifts. Even if ARM caps are in place, monthly payments can increase quickly, especially with a six-month adjustment frequency. If you’re uncertain of your ability to maintain higher monthly payments, you may want to choose a fixed-rate mortgage.
Understand Your Options
Fixed-rate and adjustable-rate mortgages are both good options for home buyers. The important thing is to understand the difference between these two choices and to evaluate your specific situation. When you factor in these issues, you can better determine which option is right for you.