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Many home buyers gravitate toward the traditional fixed-rate mortgage, but home loans aren't one-size-fits-all. You may be able to get an even lower initial interest rate 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 goals.
How a fixed-rate mortgage works
Fixed-rate mortgages have interest rates that stay the same through the life of the loan. The traditional 30-year fixed-rate mortgage is the most popular mortgage around, but 15-year and 20-year fixed-rate mortgages are available, too. Most mortgages are fixed-rate loans.
How an adjustable-rate mortgage works
An adjustable-rate mortgage begins with a set interest rate for a specified period of time. After that, the rate is adjusted periodically according to a benchmark index until the end of the loan term, which is typically 30 years.
The key to knowing how an ARM will adjust is hidden in its name: A 5-year ARM, also known as a 5/6 ARM, means your rate will be fixed for five years, then adjusted every six months, 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.
ARMs also have caps, which limit how much the interest rate can change the first time it's adjusted, in subsequent adjustments and over the lifetime of the loan.
Be careful with interest-only ARMs. These loans let you pay only interest during the introductory period. After that your payment goes way up to cover both interest and the principal.
Example: ARM vs. fixed-rate mortgage payments
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)
Is an ARM or a fixed-rate mortgage better?
The choice depends on your situation and goals.
The case for a fixed-rate mortgage
A 15- or 30-year fixed-rate mortgage may be right for you if you plan to own the home for the long haul. 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 consider refinancing into another fixed-rate mortgage at a lower rate.
Overall, fixed-rate mortgages are simpler to understand than ARMs, which can make comparing lender offerings easier.
The case for an adjustable-rate mortgage
Adjustable-rate mortgages most often appeal to first-time homebuyers because lower rates boost buying power. If you know this isn't your forever home and think you'll move in several years, an ARM could be a good choice. You'll get the benefit of a lower introductory rate in the first years of homeownership. Then ideally you'll move or trade up to a bigger home before the fixed-rate period ends.
ARM vs. fixed: Tips for choosing
To decide between an ARM or fixed-rate mortgage:
Think about how long you plan to own the home. An ARM might be worth it if you'll sell the home or pay off the mortgage in 10 years or less. But a fixed-rate mortgage would probably work better if this will be your forever home and you want the certainty of a stable interest rate and monthly payment.
If you're considering an ARM, check the caps on how much the interest rate can increase. Then calculate how much your mortgage payment would be if rates rose to those levels. Would you be able to afford the payments? If not, shop for a fixed-rate mortgage.
Whether you choose an ARM or a fixed-rate mortgage, shop around and get preapproved with at least three lenders to compare offers.
» MORE FOR CANADIAN READERS: Fixed vs. variable mortgages