Adjustable-Rate vs. Fixed-Rate Mortgages

One of the bigger decisions in choosing a mortgage is whether to lock in a rate for the life of the loan or take an adjustable rate. Neither is always better; it depends on how long you plan to keep the loan and how much payment uncertainty you're comfortable with.

Fixed-rate mortgages

With a fixed-rate loan, your interest rate and principal and interest payment stay the same for the entire term, commonly 30 or 15 years. Your total payment can still change if property taxes or insurance change.

Advantages

• Predictable principal and interest payment
• Protection if rates rise
• Simple to understand and budget for

Disadvantages

• The starting rate is often higher than an ARM's initial rate
• If rates fall, you'd need to refinance to benefit, which has costs

Adjustable-rate mortgages (ARMs)

An ARM has a fixed rate for an initial period, then adjusts periodically. You'll see them described like "7/6 ARM":

• 7 is the number of years the rate is fixed
• 6 means the rate adjusts every six months after that

Common initial periods are 5, 7 and 10 years.

How the rate adjusts

After the fixed period, your rate is set by adding a margin (fixed for the loan) to an index, a market rate that moves over time. Many ARMs today use SOFR-based indexes.

Caps

ARMs include caps that limit how much the rate can change:

• Initial adjustment cap: the most the rate can change at the first adjustment
• Periodic cap: the most it can change at each later adjustment
• Lifetime cap: the most it can ever rise above the starting rate

Your loan disclosures will show the caps and a worst-case payment. Read those carefully.

Advantages

• Initial rate is often lower than a comparable fixed rate
• Can make sense if you expect to sell or refinance before the fixed period ends
• If rates fall, your rate could adjust downward

Disadvantages

• Payment uncertainty after the fixed period
• Refinancing later isn't guaranteed. It depends on your situation, home value and rates at that time
• More moving parts to understand

How to decide

Questions I'd ask yourself:

• How long do you expect to keep this home or this loan? If you're fairly sure it's under seven years, a 7-year ARM may be worth comparing.
• Could you handle the payment at the lifetime cap? If that would be a real strain, a fixed rate may let you sleep better.
• How stable is your income? Rising income can make future adjustments easier to absorb.
• How big is the rate difference? If ARM and fixed rates are close, the fixed rate's certainty may be worth it.

An example

These numbers are for illustration only. Suppose a 30-year fixed is offered at 7% and a 7/6 ARM at 6.25% on a $700,000 loan. The ARM saves roughly $350 a month in principal and interest during the first seven years. If the borrower sells in year five, the ARM likely came out ahead. If they keep the loan for 15 years and rates are higher at adjustment, the fixed rate might have been the better choice. The math depends on what happens later, which no one can predict.

Questions?

If you're weighing a fixed rate against an ARM, I can show you both side by side, including worst-case payments, so you can decide with clear eyes. contact me, or start your pre-approval.