Fixed Rate vs Adjustable Rate Mortgage (ARM)

This type of mortgage will have the same interest rate throughout the life of the loan. This means the amount you pay every month will not change, from first payment to last. If you like consistency and financial predictability, a fixed rate is right for you. The stability of a fixed rate lets you know exactly what your payment amount will be over a long period of time. This can make monthly budgeting a lot easier and you can project your expenses far into the future for peace of mind.

Common length terms for fixed mortgages are 30, 20, and 15 years. According to Freddie Mac, in 2017, about 90% of American homebuyers choose a 30-year fixed. Why? Consistency over a long period of time is appealing to many buyers. As long as the loan doesn’t have pre-payment penalties, borrowers are free to make larger payments when they are able to. This reduces the total cost of the loan as less of the payments go towards interest.

An ARM loan is expressed with two numbers, such as 5/1, 7/1, 10/1, etc. The first number represents the number of years for which the APR on the loan will be fixed (such as 5 years, 7 years, 10 years, etc.). The second number represents how frequently the interest rate will be adjusted once the fixed rate period has expired.

For example, the rate for a 7/1 ARM is fixed for the first seven years, and then the rate will be adjusted annually beginning with the sixth year. For a 5/5 ARM, the rate is fixed for the first five years and will be adjusted every five years thereafter. It is difficult to know ahead of time if your rate and payments will increase or decrease during those adjustment periods.

If you don’t plan to live in your home for a long time, and want to afford more house, look closely at an ARM. The rates on an ARM can be lower than standard fixed-rate loans, which add up to lower monthly payments and more home-buying opportunities. However, there are risks associated with an ARM. When the rate on an ARM adjusts annually, it does so based on an index plus a margin. Although there is a limit to how much the interest rate will increase), your monthly payment could go up.

If you compare a $400,000 fixed-rate mortgage with a 5/1 ARM, it’s easy to see how time relates to savings for both options. With a fixed-rate mortgage and an interest rate of 5.00% APR and no down payment or mortgage points, you’ll pay just shy of $2,200/month for 30 years.

For an example of an ARM, let’s assume you’re approved for a 3.75% APR, with a 1.00% margin and maximum rate of 7.50%. With that loan, you’ll save $11,000 more than the fixed-rate loan after just seven years of payments. But if you choose to stay in the home for the full 30 years, the fixed-rate loan becomes the more economical decision, and saves you nearly $150,000 more than the ARM. Crunch your own numbers by visiting our mortgage calculators page.