Should You Choose a Fixed Rate Mortgage or Adjustable Rate Mortgage?

Last Updated 12/17/2014

Fixed rate mortgages (FRMs) and adjustable rate mortgages (ARMs) are the two primary types of loans home buyers can secure, and choosing one or the other can make a significant difference in how your budget develops over the term of your loan. As the names state, a fixed rate mortgage is one where the interest rate is locked in at the start of the loan term and doesn’t change after that. An adjustable rate mortgage will begin with a period of fixed interest rates, after which the rate will adjust annually according to a preset formula.

ARMs are quite tempting to home buyers because they offer lower rates and payments earlier in the repayment term. Lenders are able to use these lower rates to qualify buyers for homes that might otherwise be outside of their budget range. ARMs also allow borrowers to enjoy lowering interest rates without having to go through the refinancing process. Because payments on ARMs are generally less, borrowers will also be able to take the extra money and save or invest it elsewhere.

One of the major disadvantages of an ARM is that monthly payments will inevitably fluctuate and payments can rise quickly over the loan’s lifetime. Once the fixed rate period has passed on an ARM, the initial adjustment can be significant because certain annual caps don’t apply to it. Lenders also can make ARMs difficult to understand from a borrower’s perspective, and it’s easy to get trapped making high payments through margin determination, cap workarounds, adjustment indexes, and more. In certain circumstances, an unwary borrower can wind up owing more money than they did on closing the loan in the first place!

A fixed rate mortgage keeps monthly payments under tight control at all times, even though the rates and payments themselves tend to average higher than with ARMs. Households are given a reliable budget and FRMs are far easier to understand and plan on over the years. However, if interest rates fall, a FRM borrower will have to spend thousands of dollars to refinance. Most FRM loans are practically identical, no matter what lender you go to, and so the terms aren’t as pliable as with ARMs.

In the end, the decision should be made based on current market conditions and rates, your budget needs, risk aversion, and specific loan conditions with your lender.