Adjustable-rate vs. fixed-rate mortgage: Which should you choose? #CashNews.co

Both home buyers and homeowners considering a refinance track interest rates in the hope of getting the lowest possible rate. While most choose fixed-rate mortgages, many look at adjustable-rate mortgages (ARMs) too, which typically offer lower interest rates for an initial period.

These days, ARMs represent a small fraction of mortgage applications. For instance, an April Mortgage Bankers Association survey found that only about 7% of all mortgage applications for the week were for an ARM. Still, an ARM can be a good fit for certain people. Learn about adjustable-rate mortgages versus fixed-rate mortgages and determine which is better for you.

Read more: What is a mortgage, and how does it work?

What is an adjustable-rate mortgage (ARM)?

An adjustable-rate mortgage, just like it sounds, has a mortgage interest rate that fluctuates according to the loan terms. Most ARMs today are known as “hybrid ARM” loans because they have a fixed interest rate followed by adjustment periods when the interest rate can go up or down. The initial fixed rate on an ARM is typically lower than what you would pay with a fixed-rate loan.

Some common ARM terms lock in your rate for five, seven, or 10 years and then adjust it annually after the fixed period. Those are often called 5/1, 7/1, or 10/1 mortgages. Other ARM terms are available too, such as a 7/6 ARM, meaning you have a fixed rate for seven years and then the interest rate can adjust every six months.

Most ARMs include caps, or limits on how much your interest rate can increase or decrease during the adjustable period. Usually, there will be an initial cap on how much your mortgage can change at the first reset, a periodic cap that restricts how much your rate can change at each subsequent reset, and a lifetime cap that limits how much your interest rate can change during your entire loan term from the initial rate.

For example, if your rate during the introductory period is 6% and you have a 2/1/5 cap, your rate could only go as high as 8% or as low as 4% at the initial reset. Each subsequent reset could only change your rate by a maximum of 1%. Overall, your rate could only change by 5% over the loan’s lifetime, so your maximum possible interest rate would be 11%.

The interest rate fluctuations depend on a margin and a benchmark index, which are included in your loan documents. For example, a benchmark could be an index such as the Secured Overnight Financing Rate (SOFR), and your rate could be 2% above the SOFR rate.

Most ARMs are based on a 30-year loan term. Some mortgage lenders offer a 15-year ARM — it’s just very rare.

Dig deeper: 5 strategies to get the lowest mortgage rates

What is a fixed-rate mortgage?

A fixed-rate mortgage is less complicated than an ARM and therefore easier to fit into a financial plan. Unlike an ARM, a fixed-rate mortgage has the same interest rate for the life of the loan. That means your mortgage principal and interest payments stay the same until you refinance your home loan or pay the balance in full.

However, your property taxes and homeowners insurance premiums, often included with your mortgage payment, could change over time. Your payment could also change if you can get rid of PMI on a conventional loan.

The most common fixed-rate mortgage terms are 15 and 30 years, but some lenders offer 10- and 20-year loans or individualized loan terms.

Learn more: What is the current 30-year fixed mortgage rate?

Pros and cons of adjustable vs. fixed-rate mortgages

It’s important to understand the advantages of each type of mortgage loan to choose between an adjustable-rate mortgage versus a fixed-rate mortgage.

Advantages of ARMs include lower initial monthly payments and a lower initial interest rate during the intro-rate period. In addition, if mortgage rates decline, you would be able to pay a lower rate without refinancing when your rate resets.

However, ARMs have some disadvantages, such as the uncertainty of payments and the potential for higher payments in the future if rates trend upward. You may be at greater risk of foreclosure with an ARM because payments could increase faster than your income.

Fixed-rate mortgage loans have the advantage of stable principal and interest payments, which makes long-term budgeting simpler. However, the disadvantage is that interest rates are higher for fixed-rate loans in the initial period than for ARMs. If mortgage rates decline, you would need to refinance the mortgage to take advantage of a lower rate.

Dig deeper: Is it a good time to buy a house?

Adjustable-rate mortgage terms to know

Before you can decide between a fixed versus adjustable-rate mortgage, you’ll need to understand the terms of the ARM. You can ask your lender to explain the specifics of any individual loan program, but some of the elements of ARMs you need to examine include:

• Loan terms. ARM terms are often written as 5/1 or 7/6, with the first number indicating the fixed-rate term and the second number indicating how frequently the mortgage rate will change after the fixed period. You will also need to ask whether the total loan term is for 15 or 30 years.

• Index. The index is the benchmark for your interest rate, which can be the SOFR rate or another rate.

• Margin. The margin is the percentage above the index, such as 1% or 2%. Your interest rate is calculated according to the index plus the margin.

• Caps. Rate caps set limits on the amount your interest rate can increase or decrease, including the ceiling, which is the maximum rate the lender can charge at any time during the term.

How to choose a fixed- vs. adjustable-rate mortgage

Many people opt for a fixed-rate mortgage, but there are several factors to consider when deciding if an ARM is right for you based on your financial situation. First, think about how long you plan to stay in the home. An ARM may make sense if you are fairly certain you will move before the initial fixed-rate period ends. Then, you would benefit from a lower payment with minimal risk and a higher interest rate later. Also, if you plan to pay off your mortgage in full within a few years, an ARM can reduce your interest payments.

If you anticipate a change in your budget, such as a promised promotion with a bigger salary or a spouse who plans to return to work and add to your household income, an ARM can save you money initially, and the risk is lower that the payments will be too high if interest rates rise. Similarly, if you’re paying an expense now that will disappear, such as student loans, you may feel more confident you can afford possibly higher payments in a few years.

If you think interest rates are likely to decline in the future, an ARM can be an attractive alternative. It offers lower rates now and potentially lower rates in the future. However, you need to be financially prepared for potentially higher rates when your rate resets.

A fixed-rate loan may be the better choice for borrowers who prefer a steady payment and who plan to stay in their homes for the long term.

Compare mortgage programs, rates, and terms with a lender in the context of your financial plan to determine the best option.

Learn more: What determines mortgage rates?

How to qualify for a fixed-rate mortgage vs. an ARM

While the loan terms differ for an adjustable-rate mortgage versus a fixed-rate mortgage, the qualification process is similar. Your lender will review your credit score, income, assets, and debt-to-income ratio, which compares the minimum monthly payment on all debt with your gross (pre-tax) monthly income.

In some cases, a lender might be slightly more lenient with a higher debt-to-income ratio for an ARM. Still, you may need to show a strong work history and the likelihood of a pay increase or debt elimination in the future to show that if rates go higher, you could still afford the payment. For example, you may be on track to complete a program such as a medical residency that will result in a jump in pay, or you could have a student loan with a payoff date before the loan adjusts.

Many lenders offer ARMs with a down payment as low as 3%, just as they do for a fixed-rate mortgage. Others require slightly higher down payments.

Fixed-rate vs. adjustable-rate mortgage FAQs

Is it ever a good idea to choose an adjustable-rate mortgage vs. fixed?

An ARM could be a good choice if you plan to pay off your mortgage or sell your home before the mortgage rate resets. Also, if you can easily afford your mortgage payment with a higher rate in the future, it may be worth the risk of higher rates later to pay a lower rate now.

Why do borrowers choose an ARM instead of a fixed-rate loan when interest rates are high?

When interest rates are low, borrowers tend to want to lock in their rate for the long-term benefit. When interest rates are high, borrowers try to find a way to pay a lower rate. ARM rates are usually lower than fixed rates during their initial period.

What is the disadvantage of an ARM vs. a fixed-rate mortgage?

The main disadvantage of an ARM is the risk that interest rates will rise and your mortgage payment will increase.

Can you refinance an ARM into a fixed-rate mortgage?

You can refinance an ARM like any other mortgage into either a fixed-rate mortgage or a new ARM.

This article was edited by Laura Grace Tarpley