Adjustable-Rate v.s Fixed Rate Mortgage: What's the Right Choice?

13 Jul 2020

When applying for a mortgage loan, homeowners have a few options they can consider. The traditional fixed-rate mortgage plan is popular among buyers but it isn’t ideal for everyone. For some people, an adjustable-rate mortgage (ARM) might be more appropriate. Let’s take a look at the various differences between the two so you can decide which option is best for you. 

What is a Fixed Rate Mortgage?

A fixed-rate mortgage loan is exactly what it sounds like; it is a loan that has a constant interest rate every month. So for the life of the loan, the homeowner will owe a set amount for their monthly principal and interest payments. This offers stability and predictability to the buyer, making it the more popular option. It also prevents economic risk to an extent since your rate won’t change despite what happens in the housing market. In most cases, this financing plan will last 15 to 30 years. 

What is an Adjustable Rate Mortgage?

Unlike the fixed-rate mortgage, an ARM has varying interest payments after a specific period of time. During that initial period, the homeowner has a fixed rate. The most common choice is the 5/1 ARM, which translates to five years of fixed payments and then a change in interest rate every one year. But how is the variation in interest rate calculated?

The ARM largely relies on an index rate, which is a direct result of the market. The index rate is essentially an interest rate dictated by a neutral third party based on market activity. The lender simply adds a margin amount, that is predetermined and constant, to the index rate to give you your adjusted interest for that time. For example, if the index rate is currently 1.5 percent and the margin is 3 percent, then your current interest rate would be 4.5 percent. This may seem risky since the index can easily fluctuate and reach a heightened amount, but fortunately, ARM’s come with caps limiting how much rates can change. 

Comparison Mode

 

10/1 ARM

30 year fixed rate mortgage

Mortgage Amount

$200,000

$200,000

Initial Interest Rate

3.25%

3.75%

Interest paid after year 10

$57,549

$67,865

Annual rate increase after year 10

0.25%

0%

Interest paid after year 30

$150,236

$133,513

In this example, we’ve compared a 10/1 ARM plan to a 30-year fixed-rate mortgage. The initial fixed-rate interest amount paid with the ARM will often be less than the fixed-rate mortgage counterpart for that same time period because the interest rate is comparably lower. So after the first 10 years, you’ve saved over 10 grand through the ARM option. However, the ARM can end up costing you more over the lifetime of the loan. Given this, the choice depends on your particular situation and what you value. 

What Is Best For You?

If you…

  • value a predictable budget 
  • Have a tight income
  • plan to stay in the home permanently 
  • Expect market rates to rise in the long term

Then a fixed-rate mortgage is more ideal for you. Since this option will provide you with more stability and protection from steeply rising interest rates. 

If you...

  • Plan to move
  • Expect your income to increase
  • Expect market rates to fall in the long term
  • Want to pay off the loan in a shorter time period

Then an adjustable-rate mortgage would be the better choice. Since an ARM will allow you to take advantage of possible declining interest rates, this could prove to be more favorable. Furthermore, an ARM often provides a lower initial rate so if you plan to move, you can sell your home before the adjustment period hits, as long as you aren’t risking repayment penalties. 

Bottom Line

Although the fixed-rate mortgage plan seems safe and comfortable, it is important to assess your finances, the housing market, and your future plan with your new home before making a decision. You might realize that an ARM grants a far more cost-effective option despite its slight complexity. 

Regardless of what option you go with, never forget to compare rates and plans with multiple mortgage lenders since that is often the easiest way to avoid hefty loan payments.