There's a lot to consider when you're shopping for a mortgage, but one of the first "big picture" questions to answer is whether to get a fixed- or an adjustable-rate mortgage (ARM).
What's the difference, and why does it matter? Here's a comparison, looking at the advantages and disadvantages of each, and some guidelines on how to make the best of them.
For starters, let's define terms:
- A fixed-rate mortgage is a home loan with a set interest rate that's applicable for the entire duration of the loan (typically 30 years). It is essentially a form of installment loan, with fixed monthly payments, like student loans and most auto loans. An example would be a $250,000 loan at 4.1%.
- An adjustable-rate mortgage (ARM), offers a temporary introductory interest rate that's typically lower than those available on competing fixed-rate mortgages. But at the end of an introductory period, the interest rate shifts to a "floating" rate that's subject to central bank policies, inflation, and multiple other factors.
How Adjustable Rate Mortgages Work
Exactly how and when ARM rates are adjusted vary from loan to loan, but when they change, they almost always bring increases in monthly payments. As always, it's critical to read the loan agreement carefully before signing on, to make sure you understand all the specifics. These are variables to bear in mind when comparing ARMs:
- The length of the introductory period. Five-year introductory periods on 30-year loans are common, but one-, three-, and seven-year introductory periods are all possible.
- The index to which the floating rate is tied. Indexes commonly used to set ARM rates include the yield on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR), a controversial index that will be eliminated in 2021, but which is still widely used to set ARM rates.
- The margin added to the index to determine the rate you pay. The margin is a fixed percentage specified in the loan agreement. Margin ranges vary for different indexes, (2% to 3% with the LIBOR is fairly common). Obviously, the lower the margin, the better the loan terms are for you. Every percentage points means big dollars over the life of a 30-year mortgage.
- Rate adjustment frequency. Once the introductory period ends, the rate on an ARM resets at regular intervals. Once a year is common, but two- and three-year periods may also be used, and some ARMs reset every six months. On the reset date, a new rate is calculated by adding the margin to the value of the index on that day; the new rate applies until the next reset date.
- Rate caps. To prevent violent increases in ARM rates, ARMs typically limit the amount their interest rates can increase. A periodic cap limits the amount the rate can increase from one adjustment period to the next, while a lifetime cap limits the total amount the rate can ever increase over the introductory rate. Some ARM loan agreements also specify payment caps—limits on the amount your monthly payment can rise each readjustment period.
When comparing mortgage offers, you'll often see shorthand that summarizes interest rate, introductory period, and rate-adjustment frequency: a 3.8% 5/1 ARM, for instance, has an introductory period of five years, after which it resets every year, while a 3.75% 3/2 ARM has a three-year introductory period, after which the rate resets every two years.
For more details on the ins and outs of ARMs, the Federal Reserve has a very thorough reference available as a free download.
Pros and Cons of Fixed-Rate Mortgages
A major advantage of a fixed-rate mortgage is predictability. When your interest rate is set, you can know from day one how much your mortgage payment will be each month. That certainty simplifies household budgeting, lets you anticipate how much mortgage interest you'll be able to deduct each year on your income tax return, and makes it possible to do long-term planning with respect to paying off the mortgage. For instance, you can calculate the amount you'll spend over the life of the loan, and then determine how much you can expect to save if you pay off the loan early.
Like all interest rates, mortgage rates rise and fall with market conditions. U.S. interest rates have been remarkably low over the last decade, and mortgage rates have largely followed suit. As the Federal Reserve continues to raise its lending rate, there are indications mortgage rates may begin climbing again. That's not a major concern today, but it's a reminder of one of the potential downsides to fixed-rate mortgages. "Locking in" a 30-year fixed-rate loan in a period of high interest rates can be very costly. If interest rates go down significantly, it may be possible to refinance a high-interest loan by taking out another mortgage at a lower rate, but fees and services involved in that process can cost thousands of dollars. It may be worthwhile it to save tens of thousands of dollars over the life of the loan, but it's still a major expense.
The Ups and Downs of Adjustable Rate Mortgages
A big appeal of an adjustable-rate mortgage is its low introductory interest rate. ARM intro rates are typically lower than the rates for competing fixed-rate loans. The low rates can enable manageable monthly payments that appeal to younger borrowers early in their careers, who expect their earnings to track with, or outpace, the rate increases to come once the ARM's introductory period has ended.
Low ARM introductory rates are also attractive to borrowers who don't plan to keep their properties more than a few years. Selling a home before an ARM's introductory rate expires is a common tactic, and many ARM loan agreements discourage it by including stiff prepayment penalties. Of course, this strategy can also backfire if the local real estate market stalls or takes a downturn, making it difficult to sell the property.
The biggest disadvantage of adjustable-rate mortgages is their unpredictable nature. Increases in monthly payments every adjustment period can be a major stress on household budgets. In climates when interest rates are increasing steadily, an ARM with a payment cap can even put you in a situation known as negative amortization, in which you make your payments in full, but actually owe more money each month. Of course indexes can also decrease, bringing some relief in terms of payment amount, but not in terms of long-term predictability.
The Advantages of Adjustable Rate Mortgages
Bearing these risks in mind, one of the biggest appeals of ARMs may be that they may be more readily available than fixed-rate loans for borrowers with limited or poor credit histories. ARMs are the most common type of subprime mortgages, but their initial affordability and availability also makes them popular among borrowers with fair-to-good credit.
In today's climate of relatively low interest rates, borrowers who qualify for fixed-rate mortgages will probably be well served by the certainty of a set monthly payment. But both fixed-rate and adjustable-rate mortgages can be great vehicles for getting into a home.