The answer to your question depends on several factors including your financial priorities, risk tolerance and how long you plan to own the property. To help determine the option that is right for you, it is helpful to review a brief primer on adjustable rate mortgages.
With an adjustable rate mortgage (ARM), your interest rate is fixed for a set number of years -- usually three, five, seven or ten years -- and then the rate is subject to change and potentially increase over the duration of the mortgage, which is usually 30 years. If your mortgage rate increases, your monthly payment increases as well. This potential payment spike is the most significant risk of an ARM.
With a 3 year ARM, your rate is fixed for three years and then typically adjusts annually or semi-annually for the remaining 27 years of the loan. With a 5 year ARM, your rate is fixed for five years and then adjusts for the remaining 25 years of the mortgage.
The shorter the fixed rate period, the higher the risk the your payment increases over the course of your mortgage. In other words, you could be required to pay a higher rate and payment for a longer period of time as compared to an ARM with a longer fixed rate period.
Review How an Adjustable Rate Mortgage Works
To compensate for this higher risk, the shorter the fixed rate period for an ARM, the lower the mortgage rate, at least initially. So a 3 year ARM offers a lower rate and initial monthly payment than a 5 year ARM. This also means that you can qualify for a higher mortgage amount with a 3 year ARM as compared to a 5 year ARM.
The table below compares mortgage rates and monthly payments for ARMs. The rate and payment for shorter ARMs should be lower than for longer ARMs but this is not always the case as loan terms vary by lender and other factors. We recommend that you shop multiple lenders to find the ARM that is right for you.
If your primary goal is to reduce your initial mortgage payment or maximize your mortgage amount, then a 3 year ARM is better than a 5 year ARM, as long as you are comfortable with the additional risk.
It is impossible to predict how mortgage rates will change in the future but the shorter the fixed rate period for an ARM, the higher your risk tolerance should be. Mortgage rates may decrease in the future, which would lower your monthly payment, but you also need to be prepared for the worst case scenario.
Another important input in deciding what length of ARM is the better option is how long you intend to live in the home and have the mortgage. In an ideal scenario, you only live in the home during the initial fixed rate period and you sell the property or refinance before the loan reaches the adjustable rate period, when your interest rate and mortgage payment can potentially increase. This approach enables you to benefit from a lower initial interest rate and monthly payment but you avoid the risk of a payment spike during the adjustable rate phase of the loan.
So if you think you are going to own the property for less than three years, then a 3 year ARM makes sense. If you anticipate owning the property for less than five years then a 5 year ARM is the better choice. If you are going to own the property for a longer period of time then a 7 or 10 year ARM could be more prudent financing options.
Use ourADJUSTABLE RATE MORTGAGE CALCULATORto evaluate different ARM options
Finally, if you are unclear about how long you are going to own the property then you should consider a fixed rate mortgage. Although the interest rate for a fixed rate mortgage is usually higher than the initial rate for ARM, your rate and monthly payment do not change over the course of your loan.
Although an adjustable rate mortgage offers multiple benefits, a fixed rate mortgages provides greater certainty and peace of mind, which is why it is the most popular loan program. When it comes to selecting a mortgage, our general advice is that it is better to be safe than sorry, especially because mortgage rates are so unpredictable.
Review What Mortgage Program is Right for Me?
Ultimately the decision of what ARM or other mortgage program best meets your needs depends on your personal objectives, financial situation and timetable. It is important to consider both the advantages and the risks of each option to select the program that is right for you.