Fixed-Rate vs Adjustable-Rate Mortgage: What's Right for You?

How Fixed-Rate Mortgages Work

A fixed-rate mortgage locks in your interest rate when you take out the loan, and that rate does not change over the life of the loan. Because of this, your monthly principal and interest payment stays the same for the entire term, making budgeting straightforward and predictable.

Fixed-rate mortgages are commonly available with 15-year or 30-year terms. While the initial interest rate is generally higher than that of an adjustable-rate mortgage, the trade-off is long-term payment stability, which protects you from payment increases if interest rates rise.

• Interest rate stays the same for the entire loan term.
• Monthly principal and interest payment remains constant.
• Typically higher starting rate compared to a similar ARM.
• Common terms include 15 or 30 years.

Sources: Consumer Financial Protection Bureau, Bankrate

How ARMs Work and Rate Adjustment Indexes

An adjustable-rate mortgage (ARM) has an interest rate that can go up or down after an initial fixed period. Most ARMs have two phases: an initial fixed-rate period, often lasting 3, 5, 7, or 10 years, followed by an adjustment period during which the rate changes at specified intervals, such as monthly, every six months, or annually. For example, a 5/1 ARM has a fixed rate for the first five years and then adjusts once per year.

The actual rate on an ARM is calculated as the sum of an index plus a margin. The margin is a fixed percentage set by the lender that does not change over the loan's life. Common indexes include the U.S. prime rate, the Constant Maturity Treasury (CMT) rate, and the Secured Overnight Financing Rate (SOFR), which replaced LIBOR as a benchmark.

• Initial fixed period typical: 3, 5, 7, or 10 years.
• Adjustment period varies: could be monthly, every six months, or annually.
• Rate equals index plus margin.
• Common indexes: prime rate, CMT, SOFR.

Sources: Consumer Financial Protection Bureau, Zillow, Bankrate, Investopedia

Pros and Cons

Fixed-rate mortgages offer predictable payments, which simplifies budgeting. They protect you from payment increases if interest rates rise. However, they do not automatically benefit when rates fall; you would need to refinance to take advantage of lower rates.

Adjustable-rate mortgages typically start with a lower interest rate than fixed-rate loans, which can help with qualifying and may result in lower initial payments. If interest rates fall, your rate—and thus your payment—may decrease without the need to refinance. The downside is that your rate and payment can also increase after the initial period, which introduces uncertainty and potential budget strain.

Because fixed-rate loans have been chosen by an estimated 85–95% of borrowers from 2008 to 2022, they remain the more popular choice. However, an ARM can be a strategic option for certain situations, such as when you plan to move or refinance before the initial fixed period ends, or when high interest rates make the lower initial ARM rate appealing.

• Fixed-rate pros: predictable payments, protects against rate increases.
• Fixed-rate cons: higher starting rate, doesn't benefit from falling rates without refinancing.
• ARM pros: lower starting rate, can benefit from falling rates automatically.
• ARM cons: payments can increase, less budget certainty.

Sources: Consumer Financial Protection Bureau, Zillow, Bankrate, Investopedia

Rate Caps and Adjustment Limits for ARMs

ARMs have rate caps that limit how much the interest rate can increase at each adjustment and over the life of the loan. There are three types of caps: the initial adjustment cap, which limits the rate change from the initial fixed rate to the first adjustment; the subsequent adjustment cap, which limits rate changes at later adjustments; and the lifetime cap, which sets the maximum increase over the entire loan term.

A common cap structure is 2/1/5, meaning the rate can increase by no more than 2% at the first adjustment, 1% at each subsequent adjustment, and 5% over the life of the loan. These caps help protect borrowers from extreme payment shocks, but it's important to understand that the actual adjustments depend on the index movement and your specific loan terms.

• Three types of caps: initial, subsequent, and lifetime.
• Example structure: 2/1/5 (2% initial, 1% subsequent, 5% lifetime).
• Caps limit how much your rate can increase.

Sources: Consumer Financial Protection Bureau, Investopedia

When an ARM Might Be Advantageous

An ARM might be advantageous if you plan to move or refinance before the initial fixed-rate period ends, such as within 3 to 10 years. In that case, you could benefit from the lower initial rate without experiencing the higher payments that might occur after the adjustment period begins. Also, when interest rates are high, the lower initial ARM rate can make it easier to qualify for a mortgage and afford the initial payments.

However, ARMs carry more risk than fixed-rate loans because your payments can increase if rates rise. If you value predictable payments and plan to stay in your home for many years, a fixed-rate mortgage may be a better fit. The decision ultimately depends on your financial situation, time horizon, and risk tolerance.

• Plan to move or refinance within the initial fixed period.
• High interest rate environment may make ARM's lower initial rate attractive.
• ARMs are generally riskier than fixed-rate mortgages due to potential payment increases.

Sources: Zillow, Bankrate

Questions to Ask Before Choosing

Before deciding between a fixed-rate and an adjustable-rate mortgage, it's crucial to understand the details of any ARM you're considering. Ask your lender about the specific index, margin, rate caps, and adjustment frequency. Also, request a calculation of the maximum possible payment, so you can prepare for the worst-case scenario.

Consider your own financial plans: How long do you expect to stay in the home? Can you handle potential payment increases? Answering these questions will help you weigh the benefits of a lower initial rate against the potential for future payment changes.

• What index and margin are used for the ARM?
• What are the initial, subsequent, and lifetime caps?
• How often will the rate adjust?
• What would the maximum payment be?
• How long do you plan to stay in the home?

Sources: Consumer Financial Protection Bureau

Side-by-Side Comparison: Fixed-Rate vs. ARM

The table below summarizes the key differences between a fixed-rate mortgage and an adjustable-rate mortgage based on common features. Keep in mind that specific terms, rates, and requirements can vary by lender and market conditions.

Sources: Consumer Financial Protection Bureau, Bankrate