Fixed Rate vs. ARM Mortgages: How to Choose?

Unless you’re one of the lucky few who can avoid doing so, you’ll need to take out a mortgage when you decide to buy a home. This is obviously a big decision in itself, but it’s not the only one you’ll need to ponder as you’ll also need to choose the right type of mortgage. Various types are available, which generally fall into one of two categories: a fixed-rate or adjustable-rate mortgage (ARM).

Pros and cons are associated with each, and selecting the best choice for you will depend on a wide variety of factors. It’s essential to think carefully before making a decision; after all, your decision will have a significant impact on your long-term financial health.

In this post, we’ll run through everything you need to know about ARM and fixed-rate mortgages including how they work, corresponding pros and cons, scenarios in which either may make sense, and tips for choosing the right one for your needs. Let’s dive in.

A word on mortgages

Mortgages are loans people take out from a lender to purchase (or refinance) a property. Banks, credit unions, and other financial institutions lend money to individuals, who then repay the loan amount over a set number of years. Lenders charge interest in addition to the loan amount, and it’s the former that’s relevant to ARM and fixed-rate mortgages as they relate to the same.

How a fixed-rate mortgage works

Just as the name implies, interest rates for fixed-rate mortgages stay the same throughout the life of a loan: meaning the amount you pay on Month One of your mortgage is the same you’ll pay on Month One Hundred (and beyond).

The most common fixed-rate terms come with 15, 20, or 30-year payback periods. The shorter your term, the lower your interest rate (meaning you’ll usually score a lower rate and pay less interest over the life of a 15-year fixed-rate mortgage loan compared to a 30-year fixed mortgage). However, payments are also typically significantly higher on a 15-year mortgage.

It’s the predictability of fixed-rate mortgages that makes them the most popular mortgage type overall; per Freddie Mac—a government-sponsored enterprise responsible for keeping money flowing to mortgage lenders in support of homeownership/rental housing—approximately 90% of homebuyers choose a long-term fixed-rate mortgage.

How an adjustable-rate mortgage (ARM) works

Adjustable-rate mortgages are typically 30-year loans with variable interest rates. More specifically, they feature an introductory rate that’s fixed for an initial period—typically between 1 and 10 years—and generally lower than that of a fixed rate mortgage.

However, once the introductory period subsides, the amount of interest paid on a mortgage can go up or down depending on market conditions: meaning the monthly payment amount will shift accordingly.

Lenders often advertise ARMs with a series of number configurations (e.g., 5/1 or 7/1). The first number reflects how long the introductory period will last (i.e., how long the rate will stay the same), while the second number reflects how often the interest rate can change after the fixed period ends. Thus, in a 5/1 ARM, your introductory rate is fixed for a period of 5 years and can change annually thereafter. Note that you may occasionally see a number 6 in place of the 1; this means the rate will change every 6 months after your introductory period.

Pros of fixed-rate mortgages

They aren’t complicated
Fixed-rate mortgages are easy to understand; akin to a car loan, you make monthly payments (including principal and interest) over a specified period of time.

They’re easier to compare than ARMs
It’s much easier to shop around and compare fixed-rate mortgages than their counterparts as there are fewer variables to consider. With an ARM, meanwhile, you’ll need to compare various features such as introductory rates, introductory period length, and how much the rate can change with each adjustment/over the life of the loan.

They’re easy to budget for
Fixed-rate mortgages lend themselves to predictable monthly payments, as you’ll pay the same each month for the mortgage principal and interest throughout the duration of the loan period.

They protect you from rising interest rates
Your interest rate is locked in for the entire term, shielding you from rising interest rates.

Cons of fixed-rate mortgages

Though they’re a popular option, fixed-rate mortgages do have some drawbacks including:

You’ll pay a little more (at least initially)
Adjustable-rate mortgages come with introductory rates, meaning you’ll see a higher initial interest rate with a fixed-rate mortgage.

Your interest rate won’t budge
While fixed-rate mortgages are great if interest rates go up, you won’t be able to take advantage if they happen to go down. Accordingly, those who lock in a fixed-rate mortgage at a high interest rate may end up paying more than they would have otherwise. While you can always refinance your mortgage should rates drop, you’ll need to evaluate whether this is worthwhile as the process can easily cost anywhere between 2 and 5% of the loan’s principal (plus other fees).

You may have a difficult time qualifying
When interest rates are high, qualifying for a fixed-rate mortgage is sometimes more difficult as payments are often higher than a comparable ARM.

Pros of adjustable-rate mortgages (ARMs)

Statistically speaking, adjustable-rate mortgages are less common and make up approximately 11% of all new mortgages (per the Mortgage Bankers Association). Nevertheless, potential advantages include:

Smaller initial payments
A lower initial interest rate results in a lower mortgage payment for the first few years of your loan period, one of the primary reasons why ARMs are attractive to first-time home buyers.

Lower payment amounts
Even after the initial introductory period, you may continue to benefit should you find yourself in a falling interest rate environment. Your monthly payment will therefore also decrease without the need to worry about refinancing, but keep in mind that many ARMs feature floor rates to limit just how low they can go.

Ability to quickly pay down the principal
With a smaller monthly payment and if your budget allows, you can make additional payments towards the principal balance of the loan: thus boosting your equity more quickly.

Cons of adjustable-rate mortgages (ARMs)

Your monthly payments may increase
Though your ARM interest rate is locked in during your introductory period, monthly payments can rise alongside interest rates. This increase can pose a challenge, especially if you can’t afford the larger payments or the cost to refinance. Nevertheless, many ARMs place a cap on how much the rate and your payment can in fact increase (akin to the aforementioned decreases).

ARMs are complex
Adjustable-rate mortgages often feature complicated rules, fees, and structures and therefore pose a risk if you don’t completely understand what you’re getting into.

Larger interest expenses in the long-term
Should you decide to keep your ARM until the end of a 30-year term, you could end up paying more in interest than you would have with a fixed-rate mortgage.

When a fixed-rate mortgage may make sense

As we’ve seen, advantages and disadvantages to both fixed-rate and adjustable-rate mortgages do exist; choosing one over the other typically comes down to your individual circumstances and the overall economy. A fixed-rate mortgage tends to make sense when:

You’re buying a long-term home
Are you using the mortgage to purchase your forever home, one you plan to live in for the next few decades? A fixed-rate mortgage is perfect for the stability and predictability of a forever home and allows for easier budgeting.

You’re working within a tight budget
If you know exactly how much you can afford to spend on your mortgage each month and aren’t a fan of surprises, a fixed-rate mortgage is likely your best bet.

You’re in a low-interest-rate environment
Locking in a fixed-rate mortgage when interest rates are low can potentially save you thousands of dollars over the life of your loan.

When an ARM may make sense

Conversely, an adjustable-rate mortgage may make sense when:

You plan on moving
If you’re buying a “starter” home and want to sock away extra cash for an eventual “forever” home, an ARM may better support your goals given lower initial payments.

Interest rates are rising (or are higher than normal)
It’s not uncommon for adjustable-rate mortgages to grow in popularity in high(er)-rate environments as you won’t get locked into a higher-than-average interest rate for the duration of your loan. When rates drop following your introductory period, monthly payments will as well.

You want to pay more on your principal early on
Saving money on interest payments may add some flexibility to your budgeting, allowing you to pay down the principal balance and build equity more quickly.

The bottom line on fixed-rate and adjustable-rate mortgages

Deciding to purchase property is of course a huge decision, but it’s not the only one you’ll need to make along the way; you’ll also need to choose between an adjustable-rate or fixed-rate mortgage to fund your purchase. Given the pros and cons of each, it’s important to think carefully about which type of mortgage will best suit your circumstances, and your decision will likely come down to existing market conditions and interest rates during your search. Still not sure of which one to choose? Consider consulting with a financial expert who can steer you in the right direction.

FAQs

A mortgage rate is simply the interest amount you’ll pay a lender beyond the principal and does not reflect any fees or other charges you may incur to obtain the loan. The annual percentage rate (APR), meanwhile, is a broader measure of your mortgage cost; in addition to interest, it often includes fees and other charges you’ll pay to obtain the loan such as mortgage insurance, most closing costs, discount points, and loan origination fees. As a result, the APR is almost always higher than the mortgage rate.
A prequalification gives you an idea of how much of a loan you’ll likely qualify for, whereas a preapproval is a conditional commitment to grant you a mortgage. Read all about the differences between a prequalification and preapproval here.
While ARMs and fixed-rate loans tend to have similar credit requirements, ARMs are sometimes easier to qualify for due to smaller initial payments. For example, lenders will examine your debt-to-income ratio (your monthly debt divided by monthly gross income, expressed as a percentage) to help assess whether you’re a good candidate for a loan or mortgage. Therefore, the lower your payment, the lower your total monthly debt: boosting the chance you’ll qualify for an ARM.
A 3-2-1 buydown mortgage simply means that for the first three years of mortgage financing, your interest rate is reduced and you’ll pay the full interest rate from the fourth year onwards. These programs differ from adjustable-rate mortgages (ARMs), as the interest rate and monthly payment can change periodically for the life of the loan with the latter whereas the former features a fixed interest rate.
Discount points are a one-time fee paid directly to the lender in exchange for a reduced mortgage interest rate: an exercise also known as “buying down the rate.” Typically, the longer you reside in your home, the more it makes sense to pay for points. You should therefore only consider doing so if you’re confident you’ll remain in place for an extended period of time.