When faced with an important decision, which route do you usually take: the tried-and-true option or the one off the beaten path?
Believe it or not, your answer might affect your homebuying strategy, particularly when choosing a mortgage. Fixed-rate mortgages are time-tested and traditional, while adjustable-rate mortgages (ARMs) offer more flexibility and potentially lower rates.
But which mortgage is best for you? Stick with us to learn the differences between fixed rates and ARMs, plus the ideal buyer for each.
At a Glance
- ARMs start with lower interest rates than you’d typically see with fixed-rate mortgages but will change over time to reflect regular market rates.
- Fixed-rate mortgages stay at one consistent rate throughout the life of the loan.
- Before getting an ARM, consider the loan’s specific period lengths and rate caps.
- ARMs tend to be best when market rates are high, particularly for short-term owners, first-time homebuyers, and people who expect to pay down their mortgage quickly.
- Fixed-rate mortgages tend to be best when market rates are low, especially for buyers searching for consistent monthly payments or their forever home.
- You can refinance both ARMs and fixed-rate mortgages later in your loan to take advantage of lower interest rates.
How Does an Adjustable-Rate Mortgage (ARM) Work?
An adjustable-rate mortgage (or variable-rate mortgage) can be broken down into two key phases: the initial and adjustment periods. In the initial period, you get a below-market interest rate. When it ends, you enter the adjustment period, where your interest rate changes every few years to reflect current market rates.*
How often your loan adjusts depends on what type of ARM you choose. At ICCU, for example, homebuyers can decide between several options:
- 5-year ARM: Rate is fixed for the first 5 years, then adjusts every 6 months.
- 5/5 ARM: Rate is fixed for the first 5 years, then adjusts every 5 years.
- 7-year ARM: Rate is fixed for the first 7 years, then adjusts every 6 months.
- 10-year ARM: Rate is fixed for the first 10 years, then adjusts every 6 months.
Every ARM follows a similar structure (with an initial fixed rate and subsequent adjustments), but the length of each phase varies by lender and loan. Generally, the more often your loan adjusts (say, a 5-year compared to a 10-year ARM), the lower your rate is.
Although you can count on your ARM’s interest rate changing over time, rate caps will keep the rate from climbing too high or dropping too low. ARMs have three types of rate caps:
- An initial cap will limit your rate’s increase the first time it adjusts.
- A periodic cap will limit how much your rate changes during every subsequent rate adjustment.
- A lifetime cap will limit how much your interest rate can increase or decrease over the entire mortgage.
Not all lenders use the same rate caps. If you’re considering an ARM, remember to compare each ARM’s interest rates and rate caps.
Risks of Getting an Adjustable-Rate Mortgage
While an ARM can be a smart choice for many homebuyers, that lower initial interest rate comes with some risks.
Odds are the housing market will change throughout the life of your loan — often in ways you don’t expect. When your interest rate increases, your monthly payment will too, which can complicate your housing budget.
Before you get an ARM, ask your lender what the loan’s maximum monthly payment would be. Make sure you’re prepared to handle that payment for a few years, just in case worst comes to worst and you get stuck at a high interest rate sometime during your mortgage.
How Does a Fixed-Rate Mortgage Work?
A fixed rate’s greatest strength is also its greatest weakness. Where some homebuyers see a fixed-rate mortgage as consistent, others see it as inflexible.
Both are right.
Fixed rates tend to be less risky than adjustable ones because they change so little. Unlike an ARM, a fixed-rate mortgage stays at one interest rate** for the entire loan. That consistency tends to mean less stress and hassle over monthly payments. But less risk also means fewer opportunities. If the market’s interest rates decrease after you buy a home, yours won’t follow suit.
(Read: Reasons to Refinance)
While 15- and 30-year terms are the most popular fixed-rate mortgages, many lenders offer options between 10 and 40. Both short and long mortgages have their advantages. The shorter your mortgage is, the less you’ll pay in interest. The longer it is, the lower your monthly payments will be.
Which Type of Mortgage is Best?
No mortgage is definitively better than the others because every homebuyer has different needs. That said, your lifestyle could influence your preferences.
ARMs are generally best in high-interest real estate markets, when conventional mortgage rates may be unaffordable. They’re also good for first-time homebuyers and people who plan to move or pay off their mortgage before their initial rate changes.
Fixed-rate mortgages tend to make the most sense when mortgage rates are low. These mortgages work best for people who are looking for their forever home or for buyers who prefer less risk and more consistency.
Choose the Mortgage that Works for You
Purchasing a home is scary, even for the most seasoned buyers. But by equipping yourself with mortgage education like this, you’ll squash those fears in no time — and more importantly, prepare yourself to make the financial decisions that are right for you.
*For a $300,000 ARM loan with an initial term of 5 years and an initial 7.033% APR, the monthly payment would be $1,774.61. For a $300,000 ARM with an initial term of 7 years and an initial 6.955% APR, the monthly payment would be $1,822.83. For a $300,000 ARM loan with an initial term of 10 years and an initial 6.905% APR, the monthly payment would be $1,871.
**For a $300,000 mortgage loan with a fixed term of 30 years at 7.129% APR, the monthly payment would be $1,970.97. For a $300,000 mortgage loan with a fixed term of15 years at 6.256% APR, the monthly payment would be $2,511.36. Payment does not include taxes or insurance; the actual payment obligation will be greater. Rates as of 5/3/23 and are subject to change. All loans OAC.