What is the difference between adjustable and fixed-rate mortgages?
The primary differences between ARM vs. fixed-rate mortgages are found in their mortgage interest rate structure:
- Fixed-rate mortgage: offers the homebuyer an interest rate that will remain constant over the term of the loan, providing the predictability and security many homebuyers prefer
- ARM: typically offers a lower initial interest rate but presents the homebuyer with the possibility of higher rates during each scheduled rate adjustment period over the term of the loan.
Comparing ARM vs. fixed-rate mortgages
| Adjustable-Rate Mortgage (ARM) | Fixed-Rate Mortgage |
|---|---|
| Initially lower interest rates, but can increase over time | Interest rates remains constant throughout the loan term |
| Risk of interest rate fluctuations; payments may increase | Interest rate risk is eliminated; payments remain predictable |
| Monthly payments may change periodically based on interest rate adjustments | Fixed monthly payments throughout the loan term, providing stability |
| Term length may offer shorter initial fixed-rate periods | Typically offered with fixed terms of 15, 20, or 30 years |
| Potentially lower initial payments, beneficial for short-term ownership | Higher initial payments but provide long-term cost stability |
| May not be suitable for long-term ownership due to potential rate hikes | More suitable for long-term ownership |
What is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM), sometimes referred to as a variable-rate mortgage, is a home loan with a variable interest rate. Most ARMs utilize a hybrid model combining a lower initial interest rate followed by scheduled rate adjustments over the remaining term.
How does an adjustable-rate mortgage work?
Most ARMs feature a combination of an initial fixed rate for a defined period, followed by variable rate adjustments, up or down, on a scheduled basis. These variable adjustments are calculated using an independent financial rate index such as the Secured Overnight Financing Rate (SOFR) plus a lender-defined margin that is established at loan initiation. Most ARMs include rate-change caps per adjustment period as well as for the full term of the loan.
Types of ARMs available
There are several types of ARMs available — the most common being 3/6, 5/6, 7/6, and 10/6. The first number represents the period during which your interest rate will be fixed. The second number represents how often your interest rate can change after the fixed period expires.
- 3/6 ARM: A 3/6 ARM is a mortgage loan featuring a fixed interest rate for the first three years (“3”) followed by adjustments on a semiannual basis (“6”) over the remaining term.
- 5/6 ARM: A 5/6 ARM is a five-year fixed-rate loan period followed by semiannual adjustments over the remaining term.
- 7/6 ARM: A 7/6 ARM is a seven-year fixed-rate loan period followed by semiannual adjustments over the remaining term.
- 10/6 ARM: A 10/6 ARM is a 10-year fixed-rate loan period with semiannual adjustments to the remaining term thereafter.
What happens to my interest rate?
Following your fixed-rate period, your interest rate can increase or decrease each year for the remaining years of the mortgage. However, caps are set on your ARM to protect against these potential increases.
- An initial adjustment cap limits how much your rate can increase the first time it adjusts. For example – the initial cap on a standard 5/6 ARM is 2% – meaning your interest rate cannot increase by more than 2% at your first adjustment period.
- A periodic cap limits how much your rate can adjust at specified adjustment dates.
- A lifetime cap limits how much your rate can increase over the life of your loan.
How much will my adjustable-mortgage payment be?
For an adjustable-rate mortgage, the index is a benchmark interest rate that reflects general market conditions, and the margin is a number set by your lender when you apply for your loan. The index and margin are added together to become your interest rate when your initial rate expires.
Depending on the direction interest rates have taken, these resets can result in higher or lower monthly payments. An adjustable-rate mortgage calculator can help homebuyers understand their loan terms by showing what monthly payments will be under different scenarios.
Why would a buyer choose an ARM?
Many homebuyers are attracted to ARMs due to the benefits they provide during the initial fixed-rate period. These include:
- Lower loan payments
- Ability to apply initial savings to other needs
- Lower overall loan cost if the consumer plans to sell/move to a larger home before a scheduled rate adjustment (Note: Some ARMs include an early payoff penalty)
- Possibility of additional savings if rates are adjusted downward
The main downside of an adjustable-rate mortgage (ARM) vs. fixed is the risk of rising interest rates after the introductory fixed-rate period ends. This can lead to significantly higher monthly payments that may strain your budget.
Final thoughts
Consulting with a knowledgeable professional is the best way to find the right option for your unique situation. Homebuyers who plan to stay in their new homes over the long haul and/or have little tolerance for risk probably may be best served by a fixed-rate mortgage.
However, an adjustable-rate mortgage is an excellent choice for homebuyers seeking a lower initial interest rate combined with added flexibility to align with their unique financial needs.
