The Difference Between a Fixed Rate Mortgage and Adjustable Rate Mortgage
Many borrowers automatically choose the fixed rate mortgage, but it’s not the only option. What if you could get a lower initial interest rate and save money for a few years? That’s what an adjustable rate mortgage does for you.
No mortgage rate is a one-size-fits-all approach, though. Learn the differences between the fixed and adjustable rate mortgage below.
Understanding the Fixed Rate Mortgage
As the name suggests, the fixed rate doesn’t change. The rate you lock in and close with is the rate you have for the life of the loan. Fixed rate loans often have different term options, including 10, 15, 20, 25, and 30-year terms.
Fixed rate mortgages have several benefits:
- You always know the amount of your payment
- You aren’t affected by rising interest rates
- Easy to understand
Understanding the Adjustable Rate Mortgage
Adjustable rate mortgages start at one rate, but eventually adjust. ARMs remain fixed for a specified period. For example, a 3/1 ARM has a fixed rate for the first three years. After that point, it adjusts annually according to the current market rates. Typically, ARM loans have a fixed rate of 3, 5, 7, or 10 years.
Adjustable rate mortgages adjust according to two factors:
- The loan’s index (examples: LIBOR, Treasury Index)
- The loan’s margin (the additional amount the lender adds to the index or benchmark rate)
The loan’s index may change often, but the loan’s margin remains the same.
Adjustable rate mortgages have several benefits:
- You may save significant money during the fixed period as the introductory rate is typically lower than fixed rates
- Rates may decrease
- It’s a great short-term solution if you don’t plan to live in the home long
How Much can an ARM Rate Change?
The good news is ARM rates have caps. In fact, they have a few that help keep your rate manageable. This doesn’t mean it won’t increase, because it can, but there are limits:
- Initial adjustment cap – This limits the rate increase on your first adjustment date
- Subsequent adjustment cap – This limits the amount the interest rate can change at each adjustment
- Lifetime adjustment cap – This limits the total amount your interest rate can change over the loan’s term
When is an ARM Right?
The bigger question you may have is ‘when is an ARM the right choice?’ No two borrowers will have the same answer, but consider the following:
- Will you be in the home for the short-term?
- Do you desire to build equity faster in your home now?
- Can you take risk, not knowing what the rates will be in the future?
Once you ask yourself these questions, you’ll have a better idea of whether an ARM rate mortgage or fixed rate mortgage is better for you. Look at the big picture, including the closing costs and monthly payment to make the decision that suits you the most.