One major decision you’ll have to make when you’re about to buy a home is whether to get a fixed-rate mortgage or an adjustable rate mortgage (ARM). Let’s look at some of the differences and similarities between the two.
Overview: ARM Vs. Fixed-Rate Mortgages
As you may have guessed, there are a few specific differences between ARMs and fixed-rate mortgages. Here’s a quick overview of each type.
ARMs are 30-year loans, meaning you’ll pay back the money you borrowed over 30 years. An ARM interest rate changes after the fixed period expires. At the beginning of your loan, you’ll get a low, introductory interest rate that’s below market rates. The low rate will stay the same for a certain period of time, with the most common being 5,7 and 10 years. After the fixed-rate period ends, your interest rate will adjust up or down based on an index.
Mortgage lenders use a special series of number structures to tell you about your loan and interest periods. For example, the most common type of ARM is a 5/1 loan. The first number tells you how long the fixed interest rate lasts. The second number tells you how often your interest rate can change yearly.
A fixed-rate mortgage has the same interest rate throughout the life of your loan. Your monthly payment of principal and interest won’t change, though your overall payment can change, depending on how your taxes and homeowners insurance fluctuate.
A fixed-rate mortgage is the most popular type of financing because it’s the most predictable type of loan.
How Are ARM And Fixed-Rate Mortgages Different?
There are a few key ways that ARMs and fixed-rate loans are different. Let’s learn more.
ARMs have rate caps that limit the amount that your interest rate can rise in a single period and over the lifetime of your loan. Your loan might not increase exactly along with the market if it hits its cap.
An initial cap is the maximum percentage your rate can increase in a single period after your fixed rate period expires. A periodic cap puts a limit on the maximum amount that an interest rate can change from one adjustment period to the next.
A lifetime cap puts a limit on the total amount that your interest rate can increase from the introductory rate over the life of your loan. Your lender will express your ARM caps as a series of three numbers separated by forward slashes in this format: initial cap/periodic cap/lifetime cap. This is your “cap structure.” So, an ARM with a 2/2/5 cap structure means that your loan can increase up to 2% during your first adjustment and up to 2% with every periodic adjustment after that. Finally, your interest rate can’t increase more than 5% above the initial rate over the entire lifetime of your loan.
Let’s look at an example of how your rates and monthly payments might change with an ARM. The following is an example of how a 5/1 (2/2/5) loan at an initial rate of 3.99% might change with a $200,000 loan.
Fixed-rate loans keep the same interest rate until you pay off your mortgage. There’s no need to worry about rate caps with fixed loans because nothing changes.
Interest rates for ARMs are lower than fixed-rate loans, at least for a few years. Lenders usually charge a higher interest rate for fixed-rate loans because they need to predict interest changes over time. Because an ARM’s rate changes to fit the market, lenders can be more lenient with initial loan charges.
Ease Of Qualification
When you apply for a mortgage, your lender looks at how much income your household brings in a month versus how much you spend each month. This is your debt-to-income (DTI) ratio, and it’s a major factor when you get a loan. If you have a high DTI ratio, you may have an easier time qualifying for an ARM than a fixed-rate mortgage.
How Are ARM And Fixed-Rate Mortgages Similar?
Believe it or not, ARMs and fixed-rate mortgages do have a few things in common.
Both ARMs and fixed-rate loans both offer the same term lengths. A term length is the number of years you’ll spend paying off your loan. For example, ARMs and fixed-rate loans both have common 30-year term lengths.
Whether you apply for an ARM or a fixed rate, your lender will take a look at more than just your income. Your credit score plays a major role in your ability to get any type of mortgage. Your credit score is the numerical representation of your credit history. It’s a three-digit number that expresses how consistent you are when you pay back debts. Most people consider “good credit” to be a score of 700 or above. The higher your credit score, the more likely you’ll be able to get either an ARM or a fixed-rate mortgage.
Which One Is Right For You?
So, which is better: An ARM or a fixed-rate loan? The short answer: It depends.
Adjustable Rate Mortgages May Be Good For…
- Paying more on your loan early on. Do you want to spend more time paying on your mortgage principal right out of the gate? ARMs start with lower interest rates than fixed loans. This might give you some flexibility in your budget to make extra payments which can go toward paying down your principal.
- Living in your current home a short amount of time. Are you buying a “starter home” that you plan on moving out of sooner rather than later? ARMs allow you to build equity and take advantage of a lower interest rate while saving and searching for your dream home.
- A high interest rate market. When interest rates are high, it makes sense to choose an ARM. Fixed-rate mortgages use current mortgage rates as a jumping off point to calculate your rate, so you might lock into a higher-than-average interest rate for the duration of your loan. An ARM changes as the market changes, so when rates go down, your interest rate will, too.
- Getting close to retirement. If you’re close to retirement and you’re planning on selling soon, ARMs allow you to save more for retirement with lower interest rates. You may never have to see a rate adjustment depending on the terms of your loan and when you want to sell.
Fixed Rate Mortgages May Be Good For…
- Your “forever home.” Are you planning to settle down and live in your current home long term? Fixed interest rates can give you a better sense of stability with your budget and you can make extra payments toward principal to pay down your loan at any time.
- Tight monthly budgets. ARMs have low initial interest rates, but after this period ends, rates can be unpredictable. Fixed-rate loans allow you to predict what you’ll pay in interest and principal each year without factoring in market rates. If a small rate increase means financial stress for your household, you’re better off with a fixed-rate loan.
- A low interest market. If interest rates are low, you can save thousands of dollars by locking in with a low rate. Even if fixed rate loans have higher initial rates than ARMs, you’ll have the benefit of a lower interest rate when rates eventually do increase.
There are two major types of interest schedules you can choose when you buy a home: fixed and adjustable. Fixed-rate mortgages keep the same interest rate throughout the term of the loan. Adjustable rate mortgages (ARM) start with a low initial rate, then change as market interest rates change. ARMs have interest rate caps that limit how much your rates can increase per year and in total over the lifetime of your loan.
ARMs are easier to qualify for than fixed-rate loans, but you can get 30-year loan terms for both. An ARM might be better for you if you plan on living in your home for a short period of time, interest rates are high or you want to use the savings in interest rate to pay down the principal on your loan.
On the other hand, a fixed-rate loan might be better for you if you’re on a tight household budget and you plan to live in your current home for a long time.
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