Comparing ARMs vs. Fixed Rate Mortgages

Many home buyers gravitate toward the traditional fixed-rate mortgage — often with 15- or 30-year terms — but home loans aren't one-size-fits-all. You may be able to get an even lower initial interest rate, and a term that's more suitable to your needs, with an adjustable-rate mortgage, or ARM.

Comparing ARM and fixed-rate mortgages will help you choose the best home loan for your current needs and future goals.

Interest on ARMs vs. fixed-rate mortgages

The biggest difference between ARM and fixed-rate mortgages is how interest works. Fixed-rate loans have interest rates that never change. ARM rates reset at specific intervals over the full loan term. Adjustable-rate mortgages can be a powerful tool for home buyers with shorter-term goals in mind, but they do have their risks.

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A fixed-rate loan has an interest rate that never changes. An adjustable-rate mortgage has rates that may go up or down on a regular basis.”

ARMs begin with a set interest rate for a specified period of time, then the rate is adjusted periodically after that. The key to knowing how an ARM will adjust is hidden in its name: A 5/1 ARM means your rate will be fixed for five years, then adjusted annually, for example. The most common ARM terms have initial fixed-rate periods of three, five, seven or 10 years.

Although ARM interest rates start lower than fixed-rate loan rates, there’s always a chance they will reset higher several times over the life of the loan, increasing your mortgage payment.

Example: ARM vs. fixed-rate mortgage payments

5/1 ARM	30-year fixed rate mortgage
Mortgage amount: $300,000	Mortgage amount: $300,000
Interest rate: 3.5%	Interest rate: 4.5%
Payment: $1,347.13 (after five years, this payment will reset using a new interest rate that could increase it)	Payment: $1,520.06 (this payment will never change as long as you have the same mortgage)

» MORE: The pros and cons of adjustable-rate mortgages

Is an ARM or a fixed-rate mortgage better?

If you’re settled into your career, have a growing family or are ready to set down some roots in a community you love, a 15- or 30-year fixed-rate mortgage may be right for you. With a locked-in rate, you’ll always know what your payment will be. And if rates drop or your home appreciates significantly a few years into your mortgage, you can always take advantage by refinancing into another fixed-rate mortgage at the lower rate.

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Adjustable-rate mortgages most often appeal to first-time homebuyers.”

Adjustable-rate mortgages, on the other hand, most often appeal to first-time homebuyers because lower rates boost buying power. If you’re advancing in a career that could require you to move within a few years, are thinking about starting a family, or just want to keep your long-term options open, an ARM could be a good choice. You'll get the benefit of a lower introductory rate and the flexibility to move away or trade up to a bigger home before the fixed-rate period ends.

In order to entice more business, some mortgage companies allow borrowers to make interest-only payments, sometimes for periods up to 10 years. In that arrangement, your monthly payment only pays interest on the loan, and doesn’t make a dent in the balance owed. That can allow even lower payments to start, but be very careful when considering this kind of loan. You’re setting yourself up for a sizable jump in monthly payments later when the interest-only term ends. If interest rates rise during the promotional period, it can make the future payment pain even worse.

» MORE: Interest-only mortgage calculator

ARMs can feature one or more built-in caps. These may be limits on how much the interest rate can jump for the first adjustment and for each subsequent adjustment. The caps also can limit the maximum interest rate increase for the term of the loan.

Some ARMs offer a payment cap, too — a limit to how much your payment can increase. But while such a cap may limit the amount your monthly payment goes up, it might not limit the interest rate. The result can be a payment that doesn’t cover all of the interest due on the mortgage. The remainder is added to your total debt, so you might be paying interest on top of interest — and actually owing more at the end of your loan term than you did at the beginning.

ARMs involve some complicated terms and conditions, so it’s important to understand all of the lingo. Here are some common terms you should learn:

Adjustment frequency: How often your interest rate can adjust. Annually is a common frequency.

Adjustment indexes: The amount of expected interest rate change.

Discounted initial rate: Often referred to as the teaser rate, this is the fixed interest rate during the initial or introductory period.

Balloon payment: A large payment that can be charged at the end of a mortgage.

Interest-rate cap: A limit on how much your rate can rise with each adjustment.

Payment cap: A limit on how much your mortgage payment can change; usually a percentage of the loan.

Payment-option ARM: This mortgage allows borrowers to choose from several monthly payment options: an interest-only payment, a minimum payment or a fully amortizing payment. Be very cautious about signing up for this kind of loan.

The bottom line: ARM vs. fixed

ARMs have some appeal, especially for homeowners who want lower initial payments or relocation flexibility. You’ll want to do the math to make sure that if rates rise after the introductory period, your income can handle the higher monthly payments. But if interest rates stay low or even fall, adjustable-rate mortgages can potentially save you a lot of money. Fixed-rate mortgages may be a better choice for those who plan to stay put or need reliable mortgage payments that never change.