Loan options overview -> Fixed vs. Adjustable

Fixed vs. Adjustable

Although a fixed rate mortgage is the more common choice,
there may be sound strategic reasons to opt for an ARM.

Fixed rate mortgages

Fixed rate mortgages have an interest rate and a payment that is fixed for the life of the loan, and with each payment you pay interest and principal.

ADVANTAGES
DISADVANTAGES
  • Predictability–the payment does not change
  • Security–the interest rate does not increase
  • Saving–each month you build more equity in your home as your principal balance decreases
    • Higher rate–rates are higher for fixed rate mortgages than for ARMs
    • Higher payment–ARMs will usually cost less each month
    • Inflexibility– no option for a lower, interest-only payment

 

Adjustable rate mortgages

Adjustable rate mortgages (ARMs) have an interest rate that is fixed for three, five, seven or ten years. Since the financial crisis, ARMs that adjust annually or semi-annually without an initial fixed period have all but disappeared. The current crop of ARMs are sometimes referred to by names like ‘five-year fixed’ or ‘7/1 ARM’. At the end of their fixed interest rate period the interest rate and payment on these loans adjust annually. They also have a lifetime cap; for most ARMs, the interest rate can never be higher than six percentage points above the initial rate.

ADVANTAGES
DISADVANTAGES
  • Lower rate
  • Lower initial monthly payment
  • Easier qualifying–qualifying using the lower payment of an ARM may allow for a higher purchase price, or for more cash-out in a refinance
  • Potentially higher rates after the initial fixed period–the interest rate on an ARM can increase by as much as 6 percentage points after the initial fixed period
  • Higher payment after fixed period–If the interest rate of an ARM does increase after the initial fixed period, the payment may increase sharply

 

Important strategic advice

Financially conservative borrowers will often choose a fixed rate mortgage without even considering an ARM. However, there may be compelling reasons to look at an ARM:

  • If you are fairly certain about how long you will keep your mortgage, your best choice may be the loan whose initial term matches the length of time you will have that mortgage. If you’re highly likely to have a job transfer in three years, you would opt for a loan fixed for three years; if you know you’ll be starting a family in five or six years and will be moving to a larger home, you might opt for a 7-year fixed, or a 10-year fixed if you want a few additional years of added security before a rate change. A 3-year ARM may be the right choice if you know you are going to be refinancing in a year or two when you complete a major remodel, or for some other reason.
  • There are also borrowers who simply want the short-term relief of the lower payment of an ARM, or the ability to qualify for a more expensive purchase. They have reason to believe that their incomes will keep increasing, or that there will be some kind of a liquidity event in their future.
  • The variation between the interest rate on ARMs of different terms, and a 30-year fixed, can vary dramatically depending on the markets expectation of future economic activity and inflation. If the difference between the ARM and the fixed is very small—less than half a point, for example—the better choice may be to opt for the security of the fixed. As the spread widens, and the ARM is priced well below a fixed, it becomes more attractive, depending on your tolerance for risk and how long you think you will have the loan.
  • For anyone considering an ARM, have your lender walk you through the calculation of your payment should the loan go to its life cap. If you don’t feel you would be comfortable with that payment in the future, then opt for the fixed rate mortgage. Your lender can also calculate the worst-case ‘break-even’ point. You save money each month with the lower rate on an ARM during the fixed period, because your payment is lower with an ARM than with a fixed. However, after the loan begins to adjust, the savings will eventually be eaten away if the interest rate rises sharply; the worst-case break even point is the moment in time when your savings from the ARM during the fixed period have been eaten up by an ARM that has gone to its life cap.