Fixed vs Adjustable-Rate Mortgage: What’s the Difference?

If you don’t refinance, your mortgage payments may rise significantly once the fixed-rate period ends. If you’re buying your forever home, think carefully about whether an ARM is right for you. Interest-only ARMs are adjustable-rate mortgages in which the borrower only pays interest (no principal) for a set period. Once that interest-only period ends, the borrower starts making full principal and interest payments. ARMs come with rate caps that insulate you from possible steep year-to-year increases in monthly payments.

What are ARM rate caps?

At the current average rate, you’ll pay $665.97 per month in principal and interest for every $100,000 you borrow. The average rate for a 15-year fixed mortgage is 6.29 percent, down 1 basis point from a week ago. At the conclusion of its latest meeting on Dec. 18, the Federal Reserve announced another quarter-point rate cut — the third cut in a row. Although the Fed has cut interest rates 100 basis points since September, mortgage rates have only risen, up 0.71 percentage points since September’s low, according to Bankrate data.

Fixed vs. Adjustable-Rate Mortgage: What’s the Difference?

This can lead to lower payments in the short term but introduces the risk of rising payments in the future. Understanding the benefits and risks of each type will help you make an informed decision tailored to your financial situation and homeownership plans. Bankrate.com is an independent, advertising-supported publisher and comparison service. We are compensated in exchange for placement of sponsored products and services, or by you clicking on certain links posted on our site. While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. The best mortgage rate for you will depend on your financial situation.

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These caps limit the amount by which rates and payments can change. Interest rates are unpredictable, though in recent decades they’ve tended to trend up and down over multi-year cycles. During periods of higher rates, ARMs can help you save money in the early days of your loan by securing a lower initial rate. Just keep in mind that after the introductory period of the loan, the rate — and your monthly payment — might go up. The initial borrowing costs of an ARM are fixed at a lower rate than what you’d be offered on a comparable fixed-rate mortgage. But after that point, the interest rate that affects your monthly payments could move higher or lower, depending on the state of the economy and the general cost of borrowing.

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See the table below for a detailed breakdown of how each loan type moved. We’re transparent about how we are able to bring quality content, competitive rates, and useful tools to you by explaining how we make money. Two key factors known as “index” and “margin” determine your ARM’s interest rate. When interest rates are falling, the interest what is adjustable rate mortgage rate on an ARM mortgage will decline without the need for you to refinance the mortgage. To make sure you can repay the loan, some ARM programs require that you qualify at the maximum possible interest rate based on the terms of your ARM loan. Another key characteristic of ARMs is whether they are conforming or nonconforming loans.

Initial Costs and Long-Term Payments

• A fixed-rate mortgage, on the other hand, has one set interest rate that doesn’t change for the life of your loan.
• As you explore your options, think about all the factors that could make an ARM ideal for your situation, or could make an ARM a challenge for you in the future.
• If something looks different from what you expected, ask your lender why.
• This can save you a lot of money if you plan to only stay in your home for a few years and want to take advantage of the lower rate while you live there.

They’re advantageous in certain situations, but compared to their fixed-rate counterparts, their unique interest rate structure can be difficult for some borrowers to understand. Eligible military borrowers have extra protection in the form of a cap on yearly rate increases of 1 percentage point for any VA ARM product that adjusts in less than five years. Previous attempts to introduce such loans in the 1970s were thwarted by Congress due to fears that they would leave borrowers with unmanageable mortgage payments.

Advantages of Fixed-Rate Mortgages

But payments will balloon later on, and when this happens you will still have the full loan balance to pay off. Keep in mind that adjustable mortgage rate don’t always increase. If the index rate to which your loan is tied has fallen by the time your loan adjusts, your rate and payment also have to potential to go down. The initial period of an ARM where the interest rate remains the same typically ranges from one year to seven years. An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early, before interest rates can rise. While there are rate caps in place to protect you, that doesn’t mean your rate and payment can’t increase significantly over time.

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A fixed-rate mortgage is a type of home loan where the interest rate remains constant throughout the entire term of the loan. This means that the monthly payments for principal and interest will not change, providing stability and predictability for homeowners. If you’re confident you’ll be moving before the fixed-rate period ends, an ARM could be a great choice. You’ll enjoy the perks of a cheaper introductory rate and payment, and then move before your low rate expires. If your plans change and you no longer plan to move, refinancing to a fixed-rate mortgage could be a viable option.

How ARM rate caps work

• An ARM has a variable interest rate, while a fixed-rate mortgage has a constant rate for the entire loan term.
• Some of the most common terms are 5/1, 7/1, and 10/1 ARMs, but many lenders offer shorter or longer intro periods.
• These adjustments are based on a market index—the Secured Overnight Financing Rate (SOFR) being the most common for adjustable-rate products—that your lender uses to set and follow rates.
• Opting to pay the minimum amount or just the interest might sound appealing.
• But payments will balloon later on, and when this happens you will still have the full loan balance to pay off.
• This type of mortgage can be a more affordable means to get into a home, especially when higher rates on fixed mortgages are beginning to price some borrowers out.

Fixed and adjustable-rate mortgages choosing depends on your financial goals and risk tolerance. Fixed-rate mortgages offer stable interest rates and predictable monthly payments, ideal for long-term planning and security. Adjustable-rate mortgages (ARMs), on the other hand, start with lower initial interest rates, which can adjust periodically based on market conditions.

Adjustable-rate loans are changing, because a widely-used interest rate index expires in June

Then, the rate adjusts every year after that, which is what the second number indicates. One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip.

Adjustable-Rate Mortgage (ARM): What It Is and Different Types

A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. This means that you benefit from falling rates and also run the risk if rates increase. The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

• When you get a mortgage, you’ll pay interest on the money you borrow.
• Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions.
• There’s also the need to verify that your current finances can accommodate a higher payment down the road — even if you plan to move before the lower-rate period ends.
• With a rate cap structure of 2/2/5, your rate could increase up to 5% at its first adjustment; as high as 7% at its second adjustment; and no higher than 8% over the entire life of the loan.
• These caps limit the amount by which rates and payments can change.
• For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years.
• Yes, if your ARM loan comes with a “conversion option.” Lenders may offer this choice with conditions and potentially an extra cost, allowing you to convert your ARM loan to a fixed-rate loan.

Adjustable-rate mortgage FAQ

Fixed-rate mortgages are the most popular choice for mortgage borrowers. The stable rate and payment make FRMs a safer option for homeowners because they never risk their payments rising and becoming unaffordable. The traditional 30-year fixed-rate mortgage is the most common type of home loan, followed by the 15-year fixed-rate mortgage. If you’ve ever seen a buying option like 5/1 or 7/1 ARM, that’s a hybrid adjustable-rate mortgage. For these types of loans, the interest rate is fixed for a set number of years—like three, five or seven, for example.

If you are considering an ARM, calculate the payments for different scenarios to ensure you can still afford them up to the maximum cap. For instance, if you take out a 5/1 ARM with an index at 3% and a margin of 2%, your intro rate is 5%. Let’s say when the intro period ends, the index has dropped to 1.5% — your rate for the following year will be 3.5% (1.5% index + 2% margin). We’re the Consumer Financial Protection Bureau (CFPB), a U.S. government agency that makes sure banks, lenders, and other financial companies treat you fairly.

• Using the 5/1 ARM example, after your fixed rate expires, your interest rate could adjust up or down once each year.
• This type of mortgage can be a more affordable means to get into a home, especially when higher rates on fixed mortgages are beginning to price some borrowers out.
• If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.
• With an I-O home loan, you’ll have smaller monthly payments that increase over time as you eventually start to pay down the principal balance.
• Here’s how to know if you should get an adjustable-rate mortgage.
• Borrowers faced sticker shock when their ARMs adjusted, and their payments skyrocketed.
• However, fixed-rate loans provide the assurance that the borrower’s rate will never shoot up to a point where loan payments may become unmanageable.

Rates will depend on your mortgage lender, but in general, lenders reward a shorter initial rate period with a lower intro rate. Whether an adjustable-rate mortgage is the right choice for you depends on how long you plan to stay in the home, rate trends, your monthly budget, and your level of risk tolerance. Some of the most common terms are 5/1, 7/1, and 10/1 ARMs, but many lenders offer shorter or longer intro periods. Some ARMs, such as 5/6 or 7/6 ARMs, adjust every six months rather than once per year. This is usually a few years —  anywhere from three to 10 — and your rate and payment will stay the same for that entire period.

How are variable rates on ARMs determined?

This can make it more difficult to budget mortgage payments in a long-term financial plan. ARMs have a fixed period of time during which the initial interest rate remains constant. After that, the interest rate adjusts at specific regular intervals. The period after which the interest rate can change can vary significantly—from about one month to 10 years. Shorter adjustment periods generally carry lower initial interest rates.

• Mortgage rates have decreased somewhat since earlier this year, with the 30-year fixed-rate loan down from a high of 7.39 percent in May.
• After that, the interest rate adjusts at specific regular intervals.
• With a 5/1 ARM, you would have an introductory fixed-rate period of five years.
• When interest rates are falling, the interest rate on an ARM mortgage will decline without the need for you to refinance the mortgage.
• With less purchasing power at higher fixed rates, the lower introductory rates attached to ARMs have started to look much more appealing.
• Consider consulting with a professional financial advisor to review the mortgage options for your specific situation.

We continually strive to provide consumers with the expert advice and tools needed to succeed throughout life’s financial journey. When you’ve decided which type of mortgage is best for you, reach out to a lender to get started right away. With a payment option ARM, you have a few different ways to pay back your loan. You’ll have a fixed rate for the first decade, and then the rate changes once per year after that. Yes, if your ARM loan comes with a “conversion option.” Lenders may offer this choice with conditions and potentially an extra cost, allowing you to convert your ARM loan to a fixed-rate loan. You may need a score of 640 for a conventional ARM, compared to 620 for fixed-rate loans.

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ARM loan guidelines require a 5% minimum down payment, compared to the 3% minimum for fixed-rate conventional loans. Always read the adjustable-rate loan disclosures that come with the ARM program you’re offered to make sure you understand how much and how often your rate could adjust. ARMs have been around for several decades, with the option to take out a long-term house loan with fluctuating interest rates first becoming available to Americans in the early 1980s. Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop.

The interest rate on an ARM adjusts periodically, typically once a year after the initial fixed-rate period. With an ARM, your rate stays the same for a certain number of years, called the “initial rate period,” then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and then your rate will go up or down every year. This means even if mortgage rates are on the rise and you’re set to get an increase, it won’t go up an exorbitant amount. Ask each lender to explain what kind of interest rate cap structure it uses for its ARMs as you shop around. Because ARM rates can potentially increase over time, it often only makes sense to get an ARM loan if you need a short-term way to free up monthly cash flow and you understand the pros and cons.