Mortgage 101

Comparing Fixed-Rate vs. Adjustable-Rate Mortgages

Published on: March 2, 2022

fixed rate vs adjustable rate mortgage

Think the trusty fixed-rate mortgage is your only option as a homebuyer? Far from it. When you get a mortgage, you can choose between a fixed-rate or adjustable-rate mortgage. While the traditional fixed-rate mortgage offers simplicity and stability, the ARM is a more complicated mortgage with many moving parts. Yet, an ARM may be the choice that saves you money. Comparing a fixed-rate vs. adjustable-rate mortgage can ensure you get the best loan for your plans and financial situation.

Read on to learn about the differences between fixed-rate mortgages and ARMs, how each type of loan works, and how to choose the best mortgage for your needs. 

Comparing fixed-rate vs. adjustable-rate mortgages

Here’s a quick rundown on the difference between a fixed- and adjustable-rate mortgage.  

The interest rate on a mortgage can either reset periodically or stay the same for the life of the loan. This is the crucial difference to consider when weighing an adjustable-rate vs. fixed-rate mortgage. With a fixed-rate loan, your rate and monthly payment will be stable and predictable for the life of the loan (aside from property taxes or insurance premiums, which may fluctuate). 

How does an ARM loan work? An ARM has a variable interest rate. It starts off with a low introductory rate for an initial period, often five or seven years. After the initial period expires, the interest rate resets at intervals, such as once a year.  

Lenders refer to ARMs by numbers, such as 5/1, 7/1, or 10/1. The first number indicates the length of the initial period. The second number refers to how often the interest rate changes. So, a 5/1 ARM has its initial rate for five years, then the interest rate goes up or down annually. 

An ARM has four key components: 

  • Index: Benchmark interest rate, such as LIBOR or CMT. 
  • Margin: Percentage the lender adds to the index when calculating your interest rate. 
  • Interest-rate cap: Limit on how much your rate can increase. 
  • Initial interest-rate period: Timeline in which the interest rate stays constant. 

Examples of fixed-rate and adjustable-rate mortgages

  Fixed-rate mortgage  5/1 adjustable-rate mortgage 
Amount borrowed  $300,000  $300,000 
Loan term  30 years  30 years 
Interest rate  3.5%  3.00% for years 1-5; then adjusts each year 
Monthly principal payment for years 1-5  $1,347  $1,265 
Monthly principal payments for years 6-30  Rate and payment amount remain the same throughout the loan.  Starting in year 6, the interest rate will reset annually and payment amounts will adjust. 


Adjustable-rate mortgage pros and cons

Adjustable-rate mortgages start out with lower interest rates and cheaper payments compared to fixed-rate loans, but ARMs come with the risk that the rate — and payment — will increase.  

If you’re a first-time homebuyer or someone who expects to move within a few years, an adjustable-rate loan may be right for you. By taking advantage of an ARM’s low introductory rate, you will be able to increase your buying power, secure in the knowledge that you’ll likely sell the house before the interest rate resets. That said, consider your plans carefully. If you later decide you do want to stay in the house longer, would you be able to afford the potentially higher payments?  

Some lenders market ARMs with special features that provide much lower initial monthly payments but may include significant fees or high payments later. Be sure to review the loan terms to understand the associated fees and how payments can change. Some examples are: 

  • Interest-only ARM: This loan has an interest-only initial period with small monthly payments that will increase significantly later. 
  • Payment-option ARM: This loan provides the option to choose between an interest-only payment, a traditional principal and interest payment, or a minimum payment. 

Keep in mind: Low monthly payments are great, but they do mean that you aren’t paying much — if anything — toward the principal. When you don’t pay enough on a mortgage, you can end up with what’s called “negative amortization” — an undesirable situation in which your loan balance goes up instead of down.

Pros and cons of an adjustable-rate mortgage:

Pros of ARMs  Cons of ARMs 
Lower interest rate and monthly payment than for a fixed-rate loan — at first  Risk that interest rate and monthly payment will go up 
Can be a good option if you plan to keep the home for only a few years  Complexity of keeping up with rate and monthly payment adjustments 
Good for buyers who expect their earnings to increase  Possibility for substantial and unpredictable rate increases 
A more affordable option when interest rates for fixed-rate mortgages are too high  Risk of losing the home or being forced to refinance if the monthly payment becomes unaffordable 

Fixed-rate mortgage pros and cons

Fixed-rate mortgages are simple and have predictable payments. They are a suitable choice if you want the assurance of a stable budget and don’t plan to move. If you are someone with an established career path who is looking to buy a forever home, a fixed-rate mortgage may be the right choice.  

That said, if you lock in a fixed interest rate, you could find yourself overpaying if interest rates dip significantly in the future. Should that happen, your best option would be to refinance the mortgage to lower your interest rate. 

Pros and cons of a fixed-rate mortgage: 

Pros of fixed-rate mortgages  Cons of fixed-rate mortgages 
Simple, predictable monthly payments  Higher interest rate and monthly payments initially, compared to an ARM 
Protects against rising interest rates  Risk of overpaying interest over the life of the loan if rates fall
No chance of an increase in your monthly mortgage payment  Lowering the rate requires refinancing and paying closing costs


When is it better to get a fixed-rate vs. adjustable-rate mortgage?

There’s no clear answer to which is better: a fixed- or adjustable-rate mortgage. The choice depends largely on your personal needs, financial circumstances, and external factors, such as: 

  • How long you’ll keep the home. 
  • The interest rate environment. 
  • Your ability to budget for changing monthly payments. 

How long you’ll keep the home: If you plan to keep your home for many years or are buying your forever home, a fixed-rate mortgage may be suitable for you. If you’re buying a starter home just for a few years or expect to move soon for your career, an ARM may be the optimal mortgage choice in the short term. But beware of “teaser” or “discounted” rates, unless you are certain you can afford a higher payment once the teaser rate expires. 

Interest-rate environment: A fixed-rate mortgage will often be a smart choice in a low-interest-rate environment if you’re ready to stay in a home for many years. When mortgage rates are historically low, it’s smart to lock in a fixed-rate mortgage. A fixed-rate mortgage sets you up for the long term. 

By comparison, ARMs have variable interest rates. They are more complicated and come with the risk of rising payments in the future. You can’t know in advance how much your future house payments might be, since any increase or decrease will be based on an index that changes.  

Your ability to budget for changing monthly payments: If you never want to worry about increasing your monthly budget, you may prefer to choose the predictability of a fixed-rate over a variable-rate mortgage. If you’re thinking about signing an ARM, be sure you are confident about making your house payments after the initial period ends and the payments reset.  

Fixed-rate vs. ARM FAQs

Can you pay off an ARM early?

Some ARMs charge a penalty if you refinance or pay off the loan early. Usually, this prepayment penalty applies only during the first three to five years of the mortgage. Some loans charge a fee if you refinance but not if you sell your home. Prepayment penalties can run to several thousand dollars. When considering an ARM, ask for details on any prepayment penalties. 

What is a cap on an ARM?

There are two types of caps on ARMs: interest-rate caps and payment caps. An interest-rate cap limits how much your rate can go up, either per adjustment period or for the lifetime of the loan. 

Payment caps, on the other hand, limit the amount your monthly payment can go up at each adjustment. 

Why are ARM rates sometimes higher than fixed-rate mortgages?

Initial ARM rates are typically lower than fixed-rate mortgages at the start of the loan. However, there is the chance that an ARM rate will adjust upward after the introductory interest rate expires, while the fixed-rate mortgage will keep the same rate for the life of the loan. 

If the initial interest-rate period expires during a rising interest-rate environment, and the benchmark index goes up, the ARM’s rate will go up with its index, while the fixed-rate mortgage would keep the same interest rate.  

For help comparing fixed-rate and adjustable-rate mortgages for your situation, connect with a Finance of America Mortgage Advisor. 

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