ARM vs a Fixed-Rate Mortgage
- April 21, 2022
- by Angela
When you get a mortgage there are two main types to consider. Do you want to take a loan with a fixed or adjustable rate? What are the advantages and disadvantages of both? It all depends on your budget, but also many other factors. To make the final decision, read the article to the end…
What is a fixed-rate mortgage?
Fixed means it is permanent, or unchangeable, so it follows that a fixed interest rate mortgage means the interest rate does not change over the life of the loan.
The main reason why a fixed interest rate mortgage is very popular is that your budget is stable with this option. Your payment will be the same amount every month. NOTE: there is a catch here... the escrow portion of the mortgage payment (property tax and homeowners' insurance) can and will increase slowly over time. So your payment will go up some, but that is true with any mortgage, and with a fixed rate loan you are totally insulated when interest rates rise.
To illustrate, I will take the most popular term, a 30 year fixed interest rate mortgage. If the fixed interest rate is 5% on a $350,000 loan for 30 years, my mortgage payment would be $1,878 per month (not counting taxes and home owners insurance).
Advantages of a mortgage with a fixed interest rate
- Rates and payments are the same every month.
- The stability of monthly installments makes your budgeting easier.
- If interest rates rise, your payment will not change.
- If interest rates fall you have the option of refinancing to a new fixed rate loan which would lower your payment (this process comes with fees and paperwork).
Disadvantages of a fixed-rate mortgage
- The payment can be higher than an adjustable rate mortgage, meaning you can afford less of a house.
What is an Adjustable-Rate Mortgage?
An adjustable rate mortgage or ARM is a housing loan with an interest rate (and thus payment) that can be changed by the lender periodically.
Typically with an ARM, the rate is initially locked for a certain number of years. After the lock in period is up, the bank will adjust the rate up if interest rates have gone up. The loan will specify the rules for changes to the interest rate. Typically an ARM is linked to an interest rate index which is determined by the market and published by a neutral party.
Which adjustable-rate mortgage is taken the most? The most popular is called a 5/1 ARM. The initial rate lasts for 5 years. After that, the interest rate can be changed once a year. Lenders provide different adjustable rate lock-in periods, for example 3/1 ARM, 7/1 ARM, and 10/1 ARM.
If I take out a $350,000 loan for 30 years at an interest rate of 4%, I would pay $1,670.95 per month for the first 5 years without taxes and insurance. But after 5 years, my payment could go up. If interest rates increase by 1% my payment would go up by $207. If interest rates rise by 2% my payment would go up by $427!
Advantages of a mortgage with an adjustable-rate
- Has lower interest rates in the first years of loan repayment.
- Allows borrowers to take advantage of falling rates without refinancing.
- Can help borrowers save and invest more money.
- Offers a cheaper way to buy a house for borrowers who do not plan to live in one place for a long time.
Disadvantages of an adjustable-rate mortgage
- Rates and payments can increase significantly over the life of the loan, which can affect your budget and even lead to missed payments or foreclosure.
- An ARM is much more complex than a fixed-rate loan.
- Lenders have much more flexibility in determining the terms of the loan, which can lead to you agreeing to something you don’t fully understand the implications of,
Key differences between ARMs and fixed-rate mortgages
As you have seen so far in this article, a fixed interest rate mortgage has the same rate throughout the mortgage repayment period. The rate and payment of a fixed rate loan only change if the loan is refinanced.
An ARM has a fixed interest rate mortgage at the beginning of the repayment, and later the rate changes as frequently as once per year.
ARM vs. fixed: Which should I choose?
To help you choose which type of mortgage rate is best for your budget, you need to ask yourself a few questions:
How long do you plan to stay in the house?
If you plan to stay in one house for less than 5 years, a 5/1 ARM could make sense given:
- The rate is fixed for the first 5 years
- in theory the ARM payment will be lower than an equivalent fixed rate mortgage.
This hinges on the assumption that that your plans work out and you are able to sell the property after 5 years.
What is the interest rate environment?
If interest rates are high, ARMs are a tempting option to use because of the lower initial rate. If rates fall you can keep the ARM and save on refinance costs.
When rates are very low, and only likely to go up, a fixed rate mortgage tends to make more sense.
Could you continue meeting monthly payments even if interest rates rise significantly?
Since interest rates with ARM can rise significantly, would you be able to keep making payments even if it went up $200, or $400 per month? If the answer is no then a fixed loan may be a better option since the payment won’t change.
ARMs can be a good way to save money on your mortgage if you are aware of the extra risks they come with.