Adjustable Rate Mortgages (ARMs) vs. Fixed Rate Mortgages — What Are the Differences, Advantages, and Drawbacks

If you’re in the market to buy a home, or are considering refinance options for a home you already own, you’re likely to be presented with a range of mortgage products to choose from. Making an informed decision between a fixed rate mortgage and an adjustable rate mortgage comes down to your future plans for the home and your own personal comfort level with your payments changing over time. Let’s take a look at both of these rate structures and the pros and cons of each loan type.

Fixed Rate Mortgages

When most people think of a mortgage loan, they’re thinking about a fixed rate mortgage — usually a 30-year fixed. This type of loan structure has a note rate set at the beginning, and it never changes from the first payment until the last. As a result, the monthly principal and interest payments are the same throughout the loan, and the amortization schedule is neat and simple. The loan is considered fully amortized if the entire balance is repaid by the end of the loan term.

What Are the Advantages and Drawbacks of FRMs?

In recent years, one of the biggest advantages of getting a fixed rate loan is the security of having a set rate. This benefit has been supported by an historically low interest rate environment. Homebuyers and homeowners have had the opportunity to lock in rates in the 3% to 5% range for the next 30 years, or rates in the 2% to 4% range for the next 15 years.

You do end up paying extra for the security of a fixed rate mortgage, as the interest rates are often slightly higher than adjustable rate loan programs. However, if your long-term plans for the home don’t include selling or refinancing in the future, then a fixed rate mortgage could be the best option. This is especially true if you’re concerned about rates going up and being unable to afford an upward adjustment to your monthly payments.

Adjustable Rate Mortgages

Adjustable rate mortgages, or ARMs have an initial interest rate which is set for a predetermined period of time before it is subject to adjustment based on market conditions. The amortization schedule for ARMs isn’t as clear-cut as fixed rate loans because the loan is re-amortized after each rate adjustment.

Gone are the days where you could qualify for an ARM loan based on the initial rate and payment alone. It’s hard to believe that lenders and investors thought of this as an acceptable underwriting practice fewer than 15 years ago, but this used to be the case!

Nowadays, the rules and regulations governing ARMs dictate that the initial rate, initial adjustment, adjustment caps, and lifetime caps be clearly defined and that your loan approval be based on your ability to repay the loan. Today, your ability to repay is calculated based on either the fully indexed interest rate and payment, or the fully adjusted rate and payment (a worst-case scenario of maximum adjustments up to the lifetime cap).

ARM programs are often presented as 5/1, 7/1, 10/1, or 5/2/5 ARMs. So what do all of these numbers really mean? They refer to the initial fixed-rate period of the loan, the timing of adjustments, and the rate caps in place.

For example, a 5/1 ARM is fixed for the first five years and will adjust one time per year after that. If this 5/1 ARM has a 5/2/5 rate cap structure, then in year six the maximum adjustment is 5% and every year after that the maximum adjustment is 2%, with the lifetime ceiling being 5% above or below the initial rate. It’s worth noting that the maximum adjustments aren’t guaranteed adjustments, they’re just an upper and lower limit.

What Are the Advantages and Drawbacks of ARMs?

Often, ARMs have lower initial interest rates than most fixed rate loans over the same term. The shorter the initial fixed rate period is, the lower the interest rate will generally be. This is because you’re trading the security of being protected from market conditions in the future for that lower interest rate today. However, the spread between fixed rates and adjustable rates is still relatively compressed due to favorable market conditions.

The most significant drawback of ARMs is the potential for interest rate hikes in the future, causing your monthly payments to go up over time. There are a few safeguards in place, in the form of adjustment and lifetime rate caps and ability-to-repay calculations performed by lenders to try and ensure you won’t experience a payment shock if rates go up quickly. If you’re not anticipating your future earnings to increase along with the interest rates, then this could still put a strain on your budget.

If your plans include selling the home or refinancing the loan during the initial fixed-rate period, then it makes sense to take advantage of the interest savings in the short-term. If you’re interested in building up your equity more quickly, you could use those savings to pay down the principal balance faster (assuming there aren’t any prepayment penalties).

How Do You Know Which One Is Right for You?

Choosing between a fixed rate mortgage and an adjustable rate mortgage requires that you think about your long-term plans for your home. If your plans include selling the home within a set time frame, like when your youngest child leaves home, or when you retire, then an ARM can potentially help you save on your interest payments in the meantime. On the other hand, if this is your forever-home — meaning you have no intentions of ever selling it, then locking in your rate and payments for the life of the loan protects you from future market fluctuations.

Another thing to consider when deciding between a fixed rate loan and an ARM is your level of comfortability with your rate and payments rising and falling with the markets. If you’re generally a risk-averse person, having an ARM could be a source of unwanted financial stress.

Keep in mind though, the average homeowner has their mortgage between 5 and 7 years before refinancing or selling their home, yet the 30 year fixed rate loan is the most common mortgage type. The takeaway here is that many people end up paying for the security of a fixed rate without ever fully using it.

In order to make sure you’re choosing the best possible loan option you’ll want to consider your long-term plans and goals for the home, determine whether payment savings today are worth future uncertainty, and gauge your ability to repay the loan even in a worst-case rate scenario.

Share Your Thoughts