Fixed rate and adjustable rate mortgages -- also known as ARMs -- are the two most common types of mortgages. These programs, however, work very differently and offer different advantages and disadvantages for borrowers. Below we review how to decide between an ARM and a fixed rate mortgage so you can select the option that best meets your needs.
Know Your Risk Tolerance
If you have a relatively low appetite for risk then a fixed rate mortgage usually makes more sense than an adjustable rate mortgage. This is because the interest rate and monthly payment for a fixed rate mortgage do not change over the course of the loan.
In contrast, the mortgage rate and monthly payment for an ARM is subject to change and potentially increase. To fully appreciate this point it is important to understand how ARMs work.
Adjustable rate mortgages usually have an initial fixed rate period -- which is typically the first three, five, seven or ten years of the loan. The mortgage rate and monthly payment remain constant during this initial period.
Following the fixed rate period, the interest rate and monthly payment for an ARM usually adjusts every six months or a year -- this is called the adjustable rate period of the mortgage. If interest rates increase significantly during the adjustable rate period, your monthly payment can increase which is also known as payment shock.
So if the prospect of your loan payment jumping significantly in the future makes you uncomfortable, then you are better off with a fixed rate mortgage. If you are more risk tolerant and can financially manage a potential sudden increase in your monthly payment, then an ARM is a viable mortgage program for you.
The table below shows fixed rate mortgage rates and fees for leading lenders in your area. We recommend that you compare terms from several lenders to save money on your mortgage.
Compare the Mortgage Rates
In most cases, the mortgage rate for an ARM is lower than the rate for a comparable 30 year fixed rate mortgage. Paying a lower rate reduces your interest cost and may save you money, at least initially.
When you compare interest rates for a fixed rate mortgage to an ARM, it is important to keep in mind that the rate for an ARM varies depending on the length of the fixed rate period. For example, the initial interest rate for a three year ARM is usually lower than the rate for a 10 year ARM.
The downside to a shorter fixed rate period is that your mortgage rate and monthly payment are subject to adjust for a longer period of time. For example, with a three year ARM, your rate and payment are fixed for the first three years but then may change and possibly increase for the remaining 27 years of the mortgage, which exposes you to more risk. If interest rates increase, you could be paying a much higher monthly payment than you would with a fixed rate loan.
We recommend that you compare rates for a fixed rate mortgage to adjustable rate mortgages with different lengths. This enables you to review a wider range of financing options to find the mortgage that best fits your situation.
The table below shows ARM interest rates and fees. As you can see, the rate and monthly payment for an adjustable rate mortgage varies depending on the fixed rate period and other factors. We recommend that you contact multiple lenders to find the best ARM terms.
Compare Monthly Payments
Another potential benefit of an adjustable rate mortgage is that your initial monthly payment may be lower than for a fixed rate mortgage. This is why applicants with a limited monthly budget may choose an ARM.
The starting monthly payment for an ARM is lower because your mortgage rate is lower. If you are having difficulty meeting the lender’s debt-to-income ratio requirement or you want to lower your monthly housing expense, then an ARM may be the right program to select.
Use ourADJUSTABLE RATE MORTGAGE CALCULATORto review the monthly payment for an ARM
Although the monthly payment for an ARM may increase over the course of the loan, the lower initial payment can provide more financial flexibility for the first several years of the loan.
Compare Mortgage Amounts
If you are looking to maximize the mortgage you can qualify for then an ARM may be a better mortgage option for you. Because the initial interest rate and monthly payment for an ARM is lower than for a fixed rate mortgage, you may be able to afford a higher loan amount.
The ability to qualify for a higher mortgage amount is one of the main advantages of an ARM. This may enable you to afford a higher priced home or take out more equity when you refinance.
Consider How Long You Are Going to Own Your Home
If you plan to own your home for a longer period of time, then a fixed rate mortgage is likely a better option for you because you never have to worry about your monthly payment increasing. If you know you are going to sell your home and repay your mortgage in a shorter time frame, then an ARM offers possible advantages.
For example, if you plan to sell your home or refinance your mortgage within five years then selecting a five year ARM enables you to benefit from a lower mortgage rate and monthly payment without being exposed to the risk that your payment increases when the loan adjusts. This is why it is important to consider how long you plan to own your own your home when deciding between a fixed rate mortgage or an ARM.
Confirm Mortgage Program Eligibility
While most mortgage programs permit both types of loans, some low down payment programs do not permit ARMs because of the higher risk involved for borrowers. The good news is that all loan programs allow fixed rate mortgages so you always have that option available to you.
In closing, if you are relatively risk averse, then the certainty and peace of mind afforded by a fixed rate mortgage is likely the best loan program for you. If you are more risk tolerant, you want to qualify for a higher mortgage amount or you know you are going to sell your home within a specific time frame, then an ARM could be a better mortgage choice for you.
Fixed Rate Mortgage: http://myhome.freddiemac.com/buy/fixed-rate-mortgages.html
Adjustable Rate Mortgage (ARM): https://files.consumerfinance.gov/f/201401_cfpb_booklet_charm.pdf
Learn how a fixed rate mortgage works including key loan terms and how your monthly payment is calculated.
Understand how an adjustable rate mortgage (ARM) works including important terminology as well as program benefits and risks.
Compare the positives and negatives of the three main types of mortgages -- fixed rate, ARM and interest only -- to help you determine the program that is right for you.