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ARM vs. fixed-rate mortgage

ARM vs. fixed-rate mortgage (2023)

Choose a mortgage term that’s best for your finances

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Updated: 08/24/2023

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Before you can pick out a new couch or area rug for your new home, you will need to choose a mortgage term. Most mortgage loans can come as either a fixed-rate mortgage or an adjustable-rate mortgage (ARM).

Alex Shekhtman, the CEO of LBC Mortgage, explained the difference between the two this way: “Let's start with the fixed-rate mortgage. It's like having a steady ship in a stormy sea. The interest rate stays the same for the entire loan, whether it's 15, 20 or 30 years. This type is great if you like knowing exactly what you'll pay every month.”

Shekhtman compared an ARM to a roller coaster, saying: “At the beginning — usually for 5, 7 or 10 years, the interest rate stays put. But after that, it can change based on a special number and a set extra amount. Keep in mind that your payments could go up later on.”

Key insights

Fixed mortgage rates have the same interest rate for the life of the loan, typically in 15- or 30-year terms.
ARMs have a fixed interest rate for an initial amount of time and then will have their interest rate adjusted periodically.
ARMs and fixed-rate mortgages can be refinanced to new rates and/or terms at any time.

What are adjustable-rate mortgages?

The appeal of adjustable-rate mortgages is that the initial interest rate is typically lower than the current market rate and lower than the lender’s option for fixed-rate terms. The initial fixed-rate period can vary based on lender offerings.

You will typically see it called 5/1 ARM or 10/1 ARM (or similar variations thereof, such as 3/1 or 7/1). This means the first five or 10 years are fixed, and then the new rate is reevaluated each year based on market conditions.

After the initial period of a fixed rate, the new rate can go either up or down. Most loans will have interest rate caps, though, so homeowners are protected from extreme fluctuations.

Shekhtman said ARMs are a good choice if:

You’re thinking of moving or refinancing within the first few years.
You believe interest rates will stay the same or go down soon.
You're OK with the possibility of payments changing.

ARM terms

Adjustable-rate mortgages are a bit more difficult to grasp than fixed-rate mortgages. Here are a few terms you might run into:

Adjustment frequency: This is the frequency of rate adjustments. The adjustment frequency on an ARM might be monthly, yearly or every few years.
Adjustment index: The adjustment index is a benchmark interest rate based on market conditions that is used as part of the calculation for your new interest rate on an ARM. The index used depends on the lender; two common indexes are the U.S. prime rate and the Constant Maturity Treasury rate.
Interest caps: Interest caps are limits on the interest rate increase in a given adjustment period. Some ARMs have payment caps.
Interest-only ARM: An interest-only ARM requires you to pay only your interest portion monthly for a fixed period. After this period, your loan amortizes, meaning your monthly payments increase so you can pay off the mortgage before its term is up.
Margin: The margin is the other component (with the index) used to calculate your adjustable rate. The margin is added to the index to set the new rate. It is set in the loan agreement and is a number of percentage points.

Adjustable-rate mortgage pros and cons

ARMs are a good choice for buyers who want to secure a lower interest rate out of the gate. If you sell or refinance your property before this time limit, you can save a lot on the total interest cost and monthly payment.

ARMs can be risky, though. If you occupy the property long enough for the rate to increase significantly, you’ll have to pay more overall in monthly payments and interest.

Consider these pros and cons before deciding on an ARM for your home.

Pros

Lower initial interest rates: ARMs often start with lower interest rates compared to fixed-rate mortgages, which can result in lower initial monthly payments.
Potential for lower payments: If market interest rates remain stable or decrease during the adjustable phase, you can enjoy lower rates without needing to refinance.
Fixed period options: Choose ARMs with shorter fixed periods (e.g., 3, 5, 7 years) to best fit your goals.

Cons

Interest rate risk: If market rates increase during the adjustable phase, the interest rate and monthly payments on the mortgage can rise significantly, potentially making the loan less affordable.
Refinancing costs: If you decide to refinance an ARM into a fixed-rate mortgage, closing costs and fees can eat away the potential savings.
Market dependency: Borrowers with ARMs are reliant on market conditions, which they have no control over.

» MORE: What credit score is needed to buy a house?

What are fixed-rate mortgages?

When you opt for a fixed-rate mortgage, you’ll pay a set interest rate that remains unchanged throughout the life of your loan. Though the monthly interest and principal vary in terms of payments, the total monthly payment doesn’t change. This makes budgeting easier to manage.

Fixed-rate mortgages typically come in 15- or 30-year terms, though some lenders might offer an option to choose your loan term. The longer the term, the lower your monthly payments will be, but expect to pay more in the long run for interest.

Shekhtman said fixed-rate mortgages are a good choice if:

You plan to stay in your new home for a long time.
You like the idea of paying the same amount every month.
You're worried about interest rates going up.

Fixed-rate mortgage pros and cons

Most people choose a fixed-rate mortgage because it’s straightforward, consistent and more stable than an ARM. With a fixed-rate loan, there are no surprise rate increases, and budgeting is simpler.

One downside: Rates for this type of loan tend to be higher than what ARMs offer during the initial years. That means you have to pay a higher monthly payment and interest rate at the beginning, which isn’t to your benefit if you only plan to spend a short time in the property.

Weigh the fixed-rate mortgage pros and cons to see if it is a good fit for you.

Pros

Predictable interest rate: The interest rate remains constant throughout the entire loan term, providing predictable and consistent monthly payments.
Protection from market fluctuation: Regardless of how interest rates change in the broader market, your mortgage rate remains unchanged.
Easier to understand: With a fixed-rate mortgage, the terms are simple and clear: you have a fixed interest rate that remains unchanged throughout the loan term.

Cons

Higher initial rate: Fixed-rate mortgages often start with higher interest rates compared to the initial rates of adjustable-rate mortgages.
Missed savings: If market interest rates decrease after obtaining a fixed-rate mortgage, borrowers miss out on potential savings that those with adjustable rates might enjoy.
Not best for short-term borrowers: Fixed-rate mortgages offer little flexibility if you anticipate moving or refinancing within a few years.

» MORE: How much house can I afford?

FAQ

Can you get a government-backed loan with an ARM?

Yes, government-backed loans like FHA, VA and USDA loans are available as adjustable-rate mortgages. However, terms and availability will vary by lender.

Can I convert an ARM into a fixed-rate mortgage?

Some lenders offer options to convert an ARM into a fixed-rate mortgage, usually at a predetermined time and for a fee. If your lender does not offer this option, you can always refinance your ARM into a new fixed-rate mortgage loan.

Can I pay off an ARM or fixed-rate mortgage early?

Yes. Many fixed-rate mortgages and ARMs allow borrowers to pay off the loan early without prepayment penalties. You will want to check with your lender to make sure there are no fees or rules regarding accelerating your mortgage repayment.

Bottom line

Both adjustable- and fixed-rate mortgages are good options in specific situations. If you plan to live in the property you’re buying for a long time, a fixed-rate mortgage can save you money and offer a sense of stability and consistency.

However, if you plan to stay in the property for a limited time and want the lowest monthly payment and rate to start, an ARM could be a good option for you.

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