The key difference between fixed-rate and adjustable-rate mortgages is their interest rates and how they work. Adjustable-rate mortgages tend to have rates that are one number at the outset but can go up or down later. Fixed-rate mortgages start out with one rate and aren't subject to future increases or decreases—the rate stays the same for the duration of the loan. To choose between them it helps to understand where their interest rates are now, how rates may change, and how long you plan to keep the home you're financing.
Key Takeaways
- Fixed-rate mortgages have payments that never change.
- Payments on adjustable-rate mortgages (ARMs) can change over the term of the mortgage.
- Most ARMs have fixed rates for a certain number of years before they start to adjust.
- Which type of mortgage is best for you will depend on your financial circ*mstances and the current interest rate offerings.
Fixed vs. ARM: How Rates and Payments Differ
As a starting point in your mortgage search, it helps to get quotes from several lenders to find out what kinds of rates you're likely to be eligible for. This will not only be influenced by prevailing rates in the mortgage market but by personal factors, such as your credit score, income, other debts, and how large a down payment you can afford.
While rates go up and down with some frequency (and yours may be better or worse than the average), these were some average annual rates as of July 2024:
- 30-year, fixed-rate mortgage: 6.77%
- 15-year, fixed-rate mortgage: 6.05%
- 5/1 adjustable-rate mortgage: 6.44%
A 5/1 adjustable-rate mortgages is one of a variety of ARMs you may encounter. In its case the 5/1 means that the initial interest rate is set for the first five years and then it can change every year after that.
For each $100,000 you borrow, here's what you might pay per month for those three types of mortgages based on their average rates:
- 30-year, fixed-rate mortgage: $650
- 15-year, fixed-rate mortgage: $847
- 5/1 adjustable-rate mortgage: $628 for the first 60 months, assuming a 30-year term
You'll notice that even though the 15-year fixed mortgage has a lower interest rate than the 30-year one, it has a higher monthly payment. That's because you're paying more principal each month to pay the loan off faster.
Looking only at these monthly payments, the adjustable-rate mortgage seems like it might be the best choice, although the $22 monthly difference between it and a 30-year fixed-rate loan comes to just $264 per $100,000 borrowed per year. In past years, the difference has sometimes been more substantial, especially when lenders eager for business were offering attractive teaser rates on ARMs.
However, you also need to consider the possibility that interest rates will rise at the end of five years, when the initial rate comes to an end. If you plan to move or refinance into a fixed-rate loan within five years, that won't make any difference. And it's also possible that interest rates will fall, making the ARM an even better deal.
Types of ARMs and How They Work
The most popular types of ARMs are often referred to as hybrid ARMs. They offer a fixed rate for a certain number of years, after which the rate can adjust.
The 5/1 ARM discussed above is one common example, but others might be fixed for five, seven, or 10 years and adjust once a year or every six months thereafter. In the latter case, the second number will be a six, such as a 5/6 ARM.
While ARMs can become more expensive if interest rates rise, borrowers have some protection in the form of caps that limit how much the rate can increase in any given adjustment period and overall during the life of the loan.
In the United States, the interest rate for most ARMs is based on the current U.S. Treasury rate. That is known as the index. On top of the index, the lender will add its own margin, typically several percentage points, to determine what it will charge you.
If you have an ARM, you will be protected from any rate increases while the its introductory period is in effect.
FHA Adjustable-Rate Mortgages
The Federal Housing Administration (FHA) guarantees some adjustable-rate mortgages, allowing lenders to offer them to borrowers who need more lenient credit and other requirements to qualify, as is also the case with its fixed-rate mortgages. The FHA offers ARMs with initial fixed-rate periods of from one to 10 years.
The interest rate on the one- and three-year versions cannot increase by more than 1% per year after the introductory period or by more than 5% over the life of the loan. The interest rate on the five-, seven-, and 10-year ARMs cannot increase by more than 2% per year after the introductory period, and the lifetimecap is 6%.
Like all FHA mortgages, FHA-backed ARMs require borrowers to pay an upfrontmortgage insurancepremium (MIP) of 1.75% of the loan amount. This is usually rolled into the loan, which means you'll pay interest on it, as well.
In addition, borrowers have to pay annual MIPs for either 11 years or the entire length of the loan, depending on how much money they put down.
Choosing Between a Fixed- and Adjustable-Rate Mortgage
When you take out a fixed-rate mortgage, you know before you sign your closing papers exactly how much your mortgage payment will be each and every month for as long as you keep the mortgage. Many people value this predictability.
ARMs, on the other hand, can become more costly once they begin to adjust.
As mentioned above, borrowers have some protection against unmanageable rate increases in the form of caps, which will be spelled out in the mortgage contract. A 5/1 ARM, for example, might have a cap structure of 2-2-5, meaning that in year six (after the five-year introductory period expires), the interest rate can increase by 2%. In subsequent years, the interest rate can increase by an additional 2% per year, but the total interest rate increase can never total more than 5% over the life of the loan.
For example, a 5/1 ARM with a 2-2-5 cap structure that starts out at 6.44% could conceivably shoot up to 8.44% in the sixth year if the interest rate on its index rises that much or more. However, the highest rate you would ever have to pay is 11.44%.
If you're comfortable with those possibilities (or don't expect the keep the ARM for five years anyway), an ARM might be an acceptable choice. If it makes you uneasy, a fixed-rate loan could be more appropriate.
Is an Adjustable Rate the Same as a Variable Rate?
While "adjustable rate" may be the common term, and the acronym ARM has become widely accepted shorthand, these loans can also have other names, such as variable-rate mortgages.
Do ARMs Have Terms Like Fixed-Rate Mortgages?
ARMs may be offered for different terms, such as 15 or 30 years, just like fixed-rate mortgages. However, their interest rate will be fixed for only a portion of that term after which it can change.
Can You Convert an ARM Into a Fixed-Rate Mortgage?
Some adjustable-rate mortgages (ARMs) include a clause that allows you to convert the mortgage to a fixed-rate mortgage with that same lender after a set period of time. The clause is called an ARM conversion option.
Can You Refinance an ARM With a Fixed-Rate Mortgage?
Yes, you can refinance an ARM using a fixed rate mortgage. You can also do the opposite, refinancing a fixed-rate mortgage with an ARM.
The Bottom Line
Choosing between a fixed-rate mortgage and an ARM always involves tradeoffs. A fixed-rate loan is more predictable but often costlier, at least in the short term. An ARM may be less expensive in the short term but less predictable and potentially more expensive once its initial rate expires. As of this writing (July 2024), the huge majority of new borrowers were opting for fixed rates, with ARMs representing just 5.8% of new loan applications, according to data from the Mortgage Bankers Association.
