Adjustable Rate Mortgage vs Fixed Rate: Key Differences Explained

An adjustable rate mortgage (ARM) can offer lower initial interest rates compared to a fixed rate mortgage, potentially saving you hundreds or even thousands of dollars in the short term. This can be a great option for homeowners who plan to sell or refinance their home within a few years.

However, with an ARM, your interest rate can increase over time, leading to higher monthly payments. The frequency and amount of rate adjustments vary depending on the type of ARM, but it's essential to understand the terms and conditions before committing to one.

As we'll explore further, the key differences between adjustable and fixed rate mortgages lie in their interest rates and how they're calculated. Let's dive into the specifics.

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An adjustable-rate mortgage, or ARM, is a home loan with a variable interest rate. The initial interest rate is fixed for a period of time, but then it resets periodically, usually yearly or monthly.

ARMs are also known as variable-rate mortgages or floating mortgages. The interest rate for ARMs is based on a benchmark or index, plus an additional spread called an ARM margin.

The London Interbank Offered Rate, or LIBOR, was the typical index used in ARMs until October 2020. It was replaced by the Secured Overnight Financing Rate, or SOFR, to increase long-term liquidity.

A variable-rate mortgage loan, also known as a tracker mortgage, is available to homebuyers in the U.K. These loans use a base benchmark interest rate from the Bank of England or the European Central Bank.

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Adjustable rate mortgages (ARMs) come in three main forms: Hybrid, interest-only (IO), and payment option.

A Hybrid ARM is a combination of a fixed-rate and an adjustable-rate mortgage. This type of ARM typically starts with a fixed interest rate for a set period of time, usually 3 to 10 years, before adjusting to an adjustable rate.

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Interest-only (IO) ARMs allow you to pay only the interest on your loan for a set period of time, usually 5 to 10 years. This can lower your monthly payments, but you'll still owe the principal amount at the end of the interest-only period.

A payment option ARM offers several payment options, including paying only the interest, paying down the principal, or paying a minimum amount that may not even cover the interest.

Here are the three main types of ARMs:

ARMs can be a good option for those who plan to own their home for a shorter period of time, as they often have lower starting interest rates than fixed-rate mortgages.

The introductory period for an ARM can last anywhere from a few years to several years, and during this time, you'll pay less money in interest. This can save you money on your monthly mortgage payment.

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However, if rates change, your interest rate may increase, which could raise your monthly mortgage payment.

One of the benefits of an ARM is that it may offer a lower initial rate, which can be a big advantage for homeowners who plan to sell or refinance their home before the interest rate resets.

To protect against significant interest rate moves, many ARMs set limits on how much your rate can increase or decrease during any given interval (adjustment cap) and over the life of the loan (lifetime cap).

Here are some key things to consider when looking at an ARM:

Ultimately, whether an ARM is right for you depends on your individual circumstances and financial goals. It's essential to carefully review the terms of the loan and consider your options before making a decision.

An adjustable-rate mortgage (ARM) is a type of loan where the interest rate can change over time. The fixed period, which can range from five to ten years, is the initial period where the interest rate remains the same.

During this period, the interest rate is often lower than what you'd be offered on a comparable fixed-rate mortgage. The adjusted period is when the rate changes, and changes are made based on the underlying benchmark, which fluctuates based on market conditions.

ARMs are categorized into conforming and nonconforming loans. Conforming loans meet the standards of government-sponsored enterprises like Fannie Mae and Freddie Mac, while nonconforming loans don't meet these standards.

The initial borrowing costs of an ARM are fixed at a lower rate, but after the fixed period ends, the interest rate that affects your monthly payments could move higher or lower, depending on the state of the economy and the general cost of borrowing.

ARMs are calculated based on a reference interest rate, such as the prime rate, LIBOR, or SOFR, plus a fixed margin charged by the lender. The margin stays the same, but the index rate can change, affecting the interest rate on the mortgage.

Here's a breakdown of how ARMs are typically structured:

Comparing adjustable and fixed rate mortgages can be a daunting task, but understanding the basics can help you make an informed decision.

A fixed-rate mortgage locks in both your interest rate and your monthly payments for the life of your loan, offering the peace of mind that comes with stability. This is the most traditional form of mortgage.

With a fixed-rate mortgage, your monthly payments can still fluctuate a bit due to changes in property taxes and homeowners insurance premiums. However, the portion of your payment that's loan principal and interest stays the same.

The key differences between fixed-rate and adjustable-rate mortgages lie in the variability of the interest rate. With a fixed-rate mortgage, the amount you pay towards interest each month stays constant for the loan's entire lifetime. With an ARM, the rate changes after the introductory period ends, and will continue to adjust throughout the rest of the loan term.

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Here's a quick comparison of the two:

Ultimately, the choice between a fixed-rate and adjustable-rate mortgage depends on your financial circumstances and goals. Consider your plans for homeownership, your credit score, and your budget to make an informed decision.

An adjustable-rate mortgage (ARM) might be a smart choice if you plan to hold the loan for a limited period of time and can handle rate increases in the meantime.

People who intend to hold the loan for a short period of time, individuals who expect to see a positive change in their income, and anyone who can and will pay off the mortgage within a short time frame are well-suited for ARMs.

Fixed-rate mortgages, on the other hand, are a better fit for borrowers planning to stay put, first-time homebuyers, those with a "set it and forget it" nature, those buying in a low-rate environment, and those who are cash-crunched.

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Some key differences between fixed-rate and adjustable-rate mortgages include the variability of the interest rate, initial interest rate, down payment minimum, and how interest is calculated.

Here's a comparison of an ARM and a fixed-rate mortgage:

Note that the max interest rate on an ARM wouldn't appear overnight, and lenders typically cap rate adjustments at 1 or 2 percentage points per period.

To protect against significant interest rate moves, many ARMs set limits on how much your rate can increase or decrease during any given interval (adjustment cap) and over the life of the loan (lifetime cap).

Both fixed-rate and adjustable-rate mortgages offer standard 30-year repayment options, giving borrowers a consistent and predictable payment schedule.

To qualify for either type of mortgage, you'll need good credit, as lenders assume a certain level of risk when lending you money.

You can refinance both fixed-rate and adjustable-rate mortgages down the line, which can be a key strategy for getting out of an adjustable-rate mortgage before the first rate reset.

Here are some key similarities between fixed-rate and adjustable-rate mortgages: