ARM Mortgages vs. Fixed-Rate Mortgages

Whether you’re buying a new home that will be your primary residence, or you’re purchasing an investment property, such as a long-term rental or vacation property, you’ll likely need a mortgage. There are two nain types of mortgages you can get in regards to the interest rate: adjustable-rate mortgages (better known as ARMs) and fixed-rate mortgages.

An ARM has an interest rate that varies according to market conditions, while a fixed-rate mortgage has the same interest rate over the life of the loan.

At first glance it may seem like getting an adjustable-rate mortgage is the smarter choice, but it's more complicated than that. The key to understanding the differences between adjustable-rate mortgages and fixed-rate mortgage rates is knowing how each type of loan protects you from the rise and fall of interest rates.

About ARMs

An adjustable-rate mortgage has an interest rate that varies over time along with a publicly reported index, such as the U.S. Treasury Bill or LIBOR Index. The initial interest rates are usually lower than for a fixed-rate mortgage. For example, someone borrowing $100,000 would have an initial interest rate of 3.5 percent, compared with the 4 percent or more that might be charged for a 30-year fixed-rate mortgage. Over time, interest rates on an ARM are likely to increase, while rates on a fixed-rate mortgage will stay the same.

The advantage of an adjustable-rate mortgage is that your monthly payments are lower. Also, you're able to buy a more expensive home than if you had opted for a fixed-rate loan, as the fixed-rate mortgage would mean higher mortgage payments. With an adjustable-rate mortgage, your monthly payment will remain the same for a set period of time, typically one, three, five, or seven years. When that initial period is over and the rate adjusts as per your loan agreement, your monthly payment can go up – dramatically – even if you haven't increased your loan amount. You can protect yourself from the risk of rising rates by choosing an ARM that has an interest rate cap, but you will end up paying more in closing costs.

About fixed-rate mortgages

Unlike adjustable-rate mortgages, the interest rate on a fixed-rate mortgage will not change during its term. You can lock into an interest that remains unchanged for up to 30 years, depending upon the terms of your agreement and prevailing market conditions in the area where you live. The primary advantage of a fixed-rate mortgage is that your monthly payment will stay the same for the life of your loan.

While rates are still low, it would be advantageous to borrow at a fixed rate. The advantage is that the principal and interest payments remain unchanged for the life of the loan. Fixed-rate mortgage holders are usually protected by their locked-in interest rates, but they run the risk of losing purchasing power as inflation erodes the long-term value of those low rates over time.

Refinancing

If you have the financial flexibility, the best option might be to lock in a fixed-rate loan when interest rates fall and then refinance to an ARM when they rise enough that it makes sense.

Choosing the mortgage that’s right for you

The choice between fixed-rate mortgages and adjustable-rate mortgages boils down to your views on taking risks and how long you plan on staying in your home. If you are willing to take on risk in exchange for saving money over the short term, choose an adjustable-rate mortgage. The lower your initial interest rate, the more you will save.

On the other hand, if you plan to stay put for seven years or longer, a fixed-rate mortgage provides safety and stability because your interest rates won't change.