Adjustable Rate Mortgage or Fixed Rate Mortgage

Shopping around for the best mortgage is one of the most important parts of the home-buying process. If you decide whether to choose an adjustable or a fixed-rate mortgage, here are some things to remember.

What is an Adjustable Rate Mortgage?

An adjustable-rate mortgage (ARM) has a variable interest rate, meaning the interest rate you have when you close on your home will change over the life of the loan. The initial interest rate will be set below the market rate and rise over time.

The rate will remain fixed for some time before it rises, and this period will vary depending on the loan, anywhere from one month to 10 years. In some cases, an ARM will work in your favor, but there are some terms you need to be aware of to be fully informed before selecting an adjustable rate mortgage or fixed rate mortgage, including:

Adjustment Frequency: This is the amount of time between interest rate adjustments
Adjustment Indexes: When your interest rate adjustment occurs, the adjustment is based on the index sum and the margin. The index is a benchmark that changes based on market conditions.
Margin: When adjustment occurs, the margin is added to the index to get your new interest rate. The margin is set by your lender and agreed on when you sign onto your loan. For example, if your margin is 2%, you will pay 2% + the adjustment index as your new interest rate.
Caps: negative amortization This limits how much the interest rate can increase at each adjustment period. Sometimes, a loan may also offer a cap on the total monthly payment. If your new interest rate increases the amount beyond the monthly payment cap, the additional interest will be added to the principal, also called a schedule.
Ceiling: This is the highest interest rate allowed on a loan for the life of the loan.

Pros of an ARM

The obvious benefit of an ARM is the potential savings. Suppose you can secure an interest rate far lower than the market rate. In that case, you can save thousands a year on your mortgage payments and dedicate a higher payment ratio to the loan’s principal.

Cons of an ARM

The downside of having an ARM is that you may end up paying a higher interest rate than you can afford or even higher than you need to. If you cannot refinance out of an ARM with a high interest rate, you may be stuck with a payment you regret.

What is a Fixed Rate Mortgage?

A fixed-rate mortgage is a traditional home loan in which the interest rate set at closing remains through the 15—or 30-year life of the loan. While the ratio of your payment toward interest or principal will vary monthly based on your amortization schedule, your monthly payment will remain consistent.

Pros of a Fixed Rate Mortgage

A fixed-rate mortgage comes with predictability, which equals peace of mind for many borrowers. If you prefer a contract that guarantees your mortgage terms for the next 15 or 30 years, then a fixed-rate mortgage is your obvious choice.

Refinancing to secure lower interest rates in the future may be an option to adjust interest rates on your timeline as you see the market changing favorably.

Cons of a Fixed-Rate Mortgage

The most significant downside of a fixed-rate mortgage is the higher interest rate from the beginning. In most cases, the starting interest rate of an ARM will be lower than your fixed rate.

The Bottom Line

There are benefits and drawbacks to every mortgage product available, so it’s important to be informed and shop around before selecting your mortgage. Getting pre-approval from multiple lenders and comparing term sheets is the best way to decide between an adjustable-rate mortgage and a fixed-rate mortgage. Remember that refinancing is often an option if the loan terms you selected no longer work for you, provided your credit score, income, and debt-to-income ratio will still qualify you.