ARM vs. Fixed-Rate Mortgages: What’s the Difference

If you’re exploring your options for financing a home purchase, you’ve probably encountered two of the most common types of home loans: fixed-rate mortgages and adjustable-rate mortgages (ARMs).

ARMs have an introductory period with a low teaser rate, followed by periodic interest rate adjustments. Fixed-rate mortgages remain unchanging for the full loan term.

Let’s compare ARMs versus fixed-rate mortgages, highlighting their features and differences so you can decide which one is right for you.

What Are Adjustable-Rate Mortgages (ARMs)?

An adjustable-rate mortgage (ARM) is a home loan where the interest rate can change periodically based on the loan terms.

Typically, an ARM includes an introductory period where you pay a set mortgage interest rate for the first 5 – 10 years of the loan. After this period, the rate is adjusted – subject to change – at specific times, such as every 6 months or yearly.

Introductory rate and adjustable-rate

ARMs are broken into two cycles: your starting rating, which is typically fixed for longer, and an adjustable rate that kicks in and lasts for the remainder of the loan. 

During the introductory period of an ARM, the interest rate on your mortgage won’t change, even if mortgage rates go up. Introductory periods on an ARM can vary in length from 1 – 10 years.^[1] 

Once that starting period is over, your interest rate will adjust on a set schedule, either once or twice per year. The first number indicates the introductory term and the second is how often it will adjust, with six representing months and one for a year. 

For example, a 5/1 ARM means you’ll pay the same interest rate for the first 5 years of the loan (aka the introductory rate). When the introductory rate ends, your interest rates will change once a year (hence the one in the 5/1) depending on what interest rates are doing at the time. 

In addition to the 5/1 ARM, other common ARMs include the 7/6 ARM (a 7-year introductory period and interest rate changes once every 6 months) and the 5/6 ARM (a 5-year introductory period and interest rate changes once every 6 months).

Margins and rate caps

At this point, you might be thinking mortgage lenders will increase interest rates to astronomical levels at every adjustment period. Fortunately, most ARMs have caps on how much interest rates can increase in a given year, along with legal limits on how much the interest rate can go up over the life of the loan (lifetime cap).

Lenders determine how much interest to charge based on certain indexes that track the costs associated with borrowing money. The actual interest rate you pay on your mortgage is calculated using the prices of one or more of these indexes, then adding a margin to cover their costs and turn a profit.

Let’s say you have a 5/1 ARM with an introductory rate of 5%. The introductory period has now ended, and your loan is due for an adjustment. Your lender is using an index that’s currently at 4% (you can ask your lender which index they use to determine their ARM interest rates). The lender adds a margin of 2%, leaving you with a new interest rate of 6%, which is what you’ll pay until your next adjustment period one year from now.

Though interest rates may increase on an ARM, especially after the introductory period, they can move in either direction. So if interest rates have gone down and the indexes are significantly lower than they were during your last adjustment, the rate on your ARM could potentially decrease.

What Are Fixed-Rate Mortgages?

Fixed-rate mortgages are mortgage loans with an interest rate that remains the same throughout the life of the loan. This means that even if interest rates go up or down, your principal and interest payments won’t change – unless you refinance. 

Fixed-rate mortgages range from 10 – 30 years, with 15-year and 30-year mortgages representing the most popular term lengths.^[2]

How Do ARMs and Fixed-Rate Mortgages Compare?

Both ARMs and fixed-rate mortgages have similar eligibility criteria – like a minimum credit score of 620 and a debt-to-income (DTI) ratio of 45% or less^[3] – and offer home loans that are usually 15 or 30 years in length.

The key difference between ARMs and fixed-rate mortgages is that ARMs only offer a set interest rate to start, while fixed-rate mortgages have the same interest rate for the entire loan. 

Though an ARM can have a lower initial interest rate than a fixed-rate mortgage, the interest rate on an ARM can rise considerably once that introductory rate ends. 

Another difference between an ARM and a fixed-rate mortgage is the minimum down payment requirement. While some borrowers may be able to put 3% down on a conventional fixed-rate mortgage, ARMs require a down payment of 5%.^[3]

ARM or Fixed Rate: Which Should You Choose?

When choosing between an ARM and a fixed-rate mortgage, the one that’s best for you depends on your personal financial situation.

To help you make the right choice, consider the following factors:

Are interest rates currently high or low?

Looking at current interest rates can help you determine whether you should opt for a fixed-rate or adjustable-rate mortgage.

If interest rates are lower, you might want to lock in an interest rate by choosing a fixed-rate mortgage. However, if rates are starting to climb above average and you think they might come down later, an ARM can allow you to take advantage of falling rates without having to refinance your mortgage.

How much of an interest rate jump can you afford? 

If you’re considering an ARM, you need to be prepared to take on higher payments if your interest rate increases.

Review the mortgage terms carefully before signing, and do the math to determine the maximum possible mortgage payment you might end up having to pay.

For example, if your initial monthly payment on an ARM with a 5% interest rate is $1,879 per month, you could potentially exceed $3,000 per month if the interest rate increases to the lifetime cap of 5% or 10% overall.

Though it may never be a concern, you need to be ready for increased rates if you plan on choosing an ARM.

Will your income increase in the short term?

When choosing between an ARM and a fixed-rate mortgage, another consideration to take into account is your short-term earnings potential.

If you’re a recent medical school graduate or finishing up an MBA program, there’s a chance a higher income is just around the corner. If you’re confident your income will see a boost in the near future, it may make sense to choose an ARM. 

But if your income is stable and unlikely to increase much in the short term, the predictability of a fixed interest rate might be the more practical choice.

How long do you plan to stay in your home?

The number of years you plan on owning the home can also provide some insight into whether a fixed or adjustable rate is better for you. 

If you think you’ll only live in the home for the next 5 – 6 years and you take out a 7/6 ARM, you probably won’t have to worry about dealing with many (if any) adjustment periods. But if you find your dream home and want to live there indefinitely, your situation would likely favor a fixed-rate loan.

ARM vs. Fixed Rate: How Much Home Can You Really Afford?

Before you choose between an ARM and a fixed-rate mortgage, work with a financial advisor, lender and real estate agent to figure out exactly how much home you can afford. Then, you can choose between savings today and stable payments tomorrow. 

ARMs offer lower interest rates in the short term, but you run the risk of facing higher monthly payments in the future. On the other hand, fixed-rate mortgages are safer and more stable in the long run.