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Your decision will affect not only your monthly payment, but also how long it takes to pay off your mortgage and how much interest you pay along the way.
A variable rate mortgage, or ARM, may be a better choice in very specific circumstances. But with current interest rates at record highs this year, a fixed rate mortgage is the big winner for most borrowers right now.
Differences Between Fixed Rate and Variable Rate Mortgages
The most important difference between fixed rate mortgages and ARMs is simple. A fixed rate mortgage has a mortgage interest rate that does not change. The interest rate on a variable rate mortgage changes at predetermined times, up to the limits shown in the fine print of the loan.
The rate of an ARM will be reset on different timeframes depending on the loan. The interest rate adjustment schedule is presented as a fraction. The first digit of the fraction is when the rate is initially reset, and the second digit is how often it changes after the first adjustment. Thus, a 5/1 ARM has a fixed rate for five years, then the rate adjusts annually thereafter. Typically, an ARM is a 30-year mortgage.
A fixed rate mortgage is simpler than its variable rate counterpart. The main difference that you will find with fixed rate loans is in the amortization schedule or the terms of the loan. As with ARMs, there are 30-year fixed rate mortgages. But you can also choose shorter terms, like 10 years or 15 years.
With a fixed rate mortgage, you can opt for shorter terms. You will have a larger monthly payment, you will pay off your mortgage much faster.
Pros and Cons of a Fixed Rate Mortgage
|The fixed interest rate will not change depending on the market||The interest rate may be higher than the introductory interest rate offered by ARM|
|Usually offers 30 and 15 year loan terms||If market interest rates drop, you will need to follow the process and cost of refinancing to take advantage of lower interest rates.|
Advantages and disadvantages of an ARM
|Introductory rates may be lower than fixed mortgage rates||Market interest rate changes could affect your monthly payment|
|The future rate adjustment will not affect you if you plan to sell your home before the end of the introductory period.||Less stability|
|Usually only offers 30-year loan terms|
Interest on ARMs vs. Fixed Rate Mortgages
It is difficult to calculate the exact difference in interest on an ARM loan versus a fixed rate loan over the term of the loan because it is impossible to predict how rates may change in 10, 20, or even 30 years. But one thing you can compare is the interest rate and the monthly payments for the introductory period, where the rate remains fixed.
For our example, let’s look at a $ 347,500 house (the median selling price of homes sold in the United States in 2021) with a deposit of 20%. Here’s how much that would currently cost with a fixed 30-year and 5/1 ARM over the launch period:
|30 years fixed||5/1 ARM|
|Monthly payment (taxes and other fees not included)||$ 1,191||$ 1,222|
|Total interest paid at the end of the 5-year introductory period||$ 41,890||$ 44,640|
After the introductory period, the costs become more difficult to predict as the interest rate will change each year. If the interest rate increases from the original rate, the monthly payment will increase. If the interest rate decreases from the initial rate, the monthly payment will decrease.
Is an ARM or Fixed Rate Mortgage Better?
Choosing between an ARM and a fixed rate mortgage is all about risk versus reward. With a fixed rate mortgage, the borrower sets a rate for the term of the mortgage. With an adjustable rate, the borrower takes the risk of seeing his rate increase in the future. In exchange for the increased risk, the borrower usually gets a lower starting interest rate.
The interest on an ARM or fixed rate mortgage depends on your financial situation, your goals and your tolerance for risk. For most people, the chance of getting a slightly lower interest rate up front is not worth the instability of an ARM or the risk of a significant increase in costs in the future. This is especially true in today’s pricing environment, where low rates overall mean that the difference between fixed and ARM rates may be minor.
Plus, with a fixed rate mortgage, you have the option of choosing a shorter repayment term, such as a 15-year loan. Compared to a 30-year mortgage, a 15-year home loan will have a lower interest rate but higher monthly payments. You can potentially pay more per month, but borrowers are willing to pay off debt faster and save thousands of dollars in interest payments over the life of the loan, says Nadia Alcide, a mortgage professional with Florida Mortgage Biz. And the option of taking out a shorter term mortgage is not usually available with an ARM.
Still, there are some situations where an ARM may make sense if it represents significant savings over a fixed rate loan. These include:
If you don’t keep the loan for the long term
The careers of many people allow them to expect to move once in a while and to plan for a move. For people in this position, an ARM might be a cheaper option than a fixed rate mortgage. Especially if you know you will need to move within the next 5-10 years.
But even then, you’ll want to run the numbers. With an ARM, you are still responsible for closing costs. Closing costs can be 2% to 6% of the loan amount, and for an average home, you will be paying thousands of dollars up front. If you only stay in the house for a year or two, it might be cheaper to rent than to buy with any type of mortgage.
If you can put the extra savings to work for you
When an ARM’s monthly savings are significant, you may be able to put the additional savings to good use.
The introductory period of an adjustable rate mortgage – when the rate is at its lowest – can be an opportunity to increase your retirement savings or build up your emergency fund. You can also take the money you save and pay back your principal.
If you plan to pay off your mortgage in 10 years, an ARM with a 10-year introductory rate might help you do it more easily. The extra equity you accumulate can make it easier for you to refinance or save by waiving your private mortgage insurance requirement sooner.
There is a caveat to this approach: you have to be in a situation where if your rate goes up, you can afford it. You can plan this upfront, as an ARM has limits on the one-time rate increase or the length of the loan. If at some point you are considering an MRA, be sure to ask your lender what those limits are.
If you take out a jumbo loan
Jumbo loans are non-conforming loans because they exceed the dollar amount set by Fannie Mae and Freddie Mac. For 2021, the jumbo loan limit is $ 548,250 for most of the country, but it can be up to 150% higher in areas with more expensive homes.
Because jumbo loans are not guaranteed by the government, they are riskier for lenders and have more stringent underwriting guidelines. This is why jumbo loans also have higher interest rates than conforming loans.
Due to these higher rates, the spread between jumbo ARMs and fixed rate loans can be larger than with compliant loans. So you might save more during the introductory rate period, but jumbo loans are, by definition, bigger loans. So any future price increases on a Jumbo ARM will have a bigger impact on your monthly budget.
If your income will increase
In some situations, an ARM may make sense for high net worth or high income households, says Greg McBride, chief financial analyst at Bankrate.com. If you are expecting a big increase in your income, then an ARM might be right for you. A doctor who completes his residency is a good example.
Paying less on a variable rate can provide flexibility if your income is variable or seasonal, he says. But again, he stressed that it only works in extreme cases, for example, athletes or artists.
The result: ARM vs fixed
Right now, the difference between the starting rates for adjustable mortgages is minimal or nonexistent compared to a fixed rate loan, says McBride. âIf you don’t get any benefits but still take on the same level of risk, why bother? ”
For ARMs to make more sense to people, the spread between fixed rate and variable rate mortgages would have to increase, which is more likely to happen when interest rates rise globally. Although interest rates have slowly started to rise from the lowest pandemic levels, experts predict that rates will remain relatively low for some time.
The current economic outlook only adds to the waning appeal of ARM. One situation where ARMs have traditionally made sense is when you plan to sell the property before the rate is reset. This strategy is based on an increase or at least a stability of house prices.
While house prices have gone up in many areas, due to record mortgage rates and low housing stock, no one can guarantee this will continue in the long term. And if there’s one thing the COVID-19 pandemic has taught us, it’s the importance of planning for future uncertainty. So if you are able to buy a home or refinance, foreclosure on a fixed rate is the way to go in most cases.