Fixed vs ARM Mortgage: How Do They Compare? | NerdWallet

If you've been keeping an eye on mortgage interest rates, you've noticed that they've been going up, and it's especially true for fixed rate loans. If you're in the market to buy a home and you're comparing different loan products, adjustable rate mortgages might be starting to look pretty good, even though arms can be kind of complicated. So what do you need to know in order to decide between these options? Let's talk about the differences between adjustable rate mortgages or arms and fixed rate mortgages. When it comes to mortgages, 30-year fixed rate loans are most American's go-tos. In 2021, 89% of purchase loans were 30-year fixed rate mortgages. They're generally popular because they're really easy to deal with. You get it, the interest rate stays the same for the life of the loan. It really doesn't get easier. On the other hand, adjustable rate mortgages start off with a low introductory period that's usually something like three, five, or seven years, but then when that ends, the rate changes every six months. If that sounds annoying and complicated, it pretty much is. And that is one reason why people tend to shy away from arms. That said, with interest rates going up the way they are, arms are suddenly looking a lot more attractive because those introductory rates tend to be significantly lower than rates for fixed rate mortgages. When you're looking at adjustable rate mortgages, you'll often see them described as three-year arms, five-year arms, something like that. If that seems a little bit unfamiliar, it's because that nomenclature is actually pretty new. Arm rates used to be determined by an index called the LIBOR, and that looked over a pretty long period of time, so arm rates adjusted once a year. Because of that, they'd generally be called three-one arms or five-one arms to indicate that there was a three- or five-year introductory period, and that after that, it would adjust every year. Now, arms use a completely different index called the SOFR. That adjusts every six months because it just changes more frequently. So while it makes things a bit more complicated, one thing that's good to know is that today's arms are not the adjustable rate mortgages that were devastating people back during the housing bubble and subsequent foreclosure crisis. Arms are much more regulated than they used to be. You'll get paperwork with them that is uniform from each lender, and so they're really, really easy to compare and much easier to understand than they used to be. So even when your rate starts adjusting, you are not going to be surprised by a huge payment that you suddenly owe. Doing an example might help here. Let's say you have a five-year arm with an introductory rate of 4.5% with those 215 caps. So the first number, we've got a two-percentage point initial cap. If you're starting out with a 4.5% interest rate after that five-year introductory period, your first adjustment cannot take you higher than 6.5%. Then we're at our periodic cap, the second number. So that's one percentage point. You're at that 6.5% after the initial adjustment. Your next adjustment six months later could not take you higher than 7.5%. The third number is our lifetime cap. In this case, it's five percentage points. So no matter how many adjustments you've had or what is going on with mortgage rates in general, the interest rate on your arm that started out at 4.5% can never go higher than 9.5%. Pro tip, you can also just skip all that math and ask your lender what's the most you'd have to pay with the different caps. Have them give it to you in dollar amounts so it's easy to understand and you know exactly what the most you could pay could be. Another thing that's important to note about arms is that they don't just adjust upward. If rates are falling, an arm will adjust down. That can actually be an advantage over having a fixed rate mortgage because with a fixed rate mortgage, to get a better rate, you've got to do a refinance. With an arm, it just does it for you and it adjusts. So you automatically get that lower rate. So to sum up, arms do have some definite advantages. One, there's that introductory period where you've got that nice low introductory rate. If your budget is being stretched, that can help you get into a home. Another thing is that if you aren't going to live somewhere for an especially long period of time, say it's just your starter home, you might buy and then sell the home just during that introductory period and never actually deal with the adjustable part of an arm. And then last, if we enter a falling rates environment, your arm will adjust downward on its own and you don't need to refi. But of course, there are plenty of reasons why fixed rate mortgages are as popular as they are. One, they are super easy. They are very simple to understand. They give you predictable principal and interest payments that are never going to change for the life of the loan. And they are the most widely available type of loans. Pretty much if any lender is going to offer a mortgage, they are going to offer a fixed rate loan. But if making the decision were that easy, we wouldn't even be making this video. So let's look at some numbers. Now, for this example, we're going to assume that you're making the same down payment for the same home and the same location, and that the interest rate is just going to vary based on the type of mortgage that you're using. So with a five-year arm and an interest rate of 4.5% on a $300,000 mortgage, your monthly principal and interest payment would be about $1,520 for the first five years. After that, this payment will reset to a new interest rate that could increase. Let's compare that to a 30-year fixed rate mortgage. We're starting out with a higher interest rate, 5.5%, but the same mortgage around $300,000. The monthly principal and interest payment on that would be about $2,159, but that payment's not going to change as long as you have that same mortgage. So on one hand, the adjustable rate mortgage is giving you a savings of almost $640 a month in principal and interest, but that's only for the first five years. After that, when the loan goes into its adjustable period, your interest rate could change and it could potentially go significantly higher than the 5.5% that we're using in this example on the fixed rate loan. If you need to stretch your home buying budget and you don't think you're going to live in the home for very long, an arm can actually be a really ideal solution because you're getting that nice low introductory rate, and if you move before the adjustable period, you've saved all that money. But you've got to consider that things can happen in the meantime. Maybe for whatever reason, it turns out you can't move or it's not the right time, or you just really love the house. Then you're going to need to be ready for when that adjustable period hits and have a plan. That could be staying with the adjustable mortgage. That could be refinancing to a fixed rate loan. It could even be refinancing to a different arm so that you start over with a new intro period. The thing that you've got to consider is that refinancing comes with costs and you don't want the cost of a refi to erase the savings that you just had from having that lower introductory period with the arm. Fixed rate home loans are easier than adjustable rate home loans. No cap. Also, like literally, no caps. There are no interest rate caps. Your interest rate just is what it is when you got the loan and it doesn't change for the life of the loan. So that means until you either sell your home or you refinance, your interest rate is staying exactly what it is. This is really helpful because it stabilizes a pretty large chunk of your mortgage cost, that principal and interest payment. So other things might change. Your property taxes could increase. Your homeowners association dues could change. But you know that you've always got that part of your budget set aside that that housing cost is exactly what it is and it's not going to change. It also is a hedge against inflation because while rent will go up with inflation, that fixed interest rate that you've already locked in is not going to change. If you've got a fixed rate mortgage and you love your house but you don't exactly love your loan, remember that you can always refinance if interest rates change. You're not locked in. And that's also something that's important to think about with either kind of loan because with both arms and fixed rate mortgages, 30 years is the most common loan term. Three decades is a really long time and so that can feel like a huge commitment. But it's important to remember that hardly anybody actually sticks with that loan they started out with for 30 full years. Even if you keep living in the house, even if you don't sell, most people are going to refinance. So if you were in an adjustable rate mortgage, you could refinance to a fixed. You could refinance to another arm. If you're in a fixed, you could refinance to an arm too. Or you could just refinance to another fixed to get a better rate. There are lots of different options. So when you're starting out getting a loan, that 30 years can feel scary but don't necessarily think of it in terms of what will I be doing three decades from now. Think about where will I be two, three, five years from now. Something that's more of a reasonable time horizon. And that can help you determine what kind of mortgage is going to be right for you. I'm Kate Wood and I write about mortgages and home buying for NerdWallet. If you're in the market for a mortgage, head to our website to see the latest interest rates on both adjustable and fixed rate mortgages. But as long as you're here, why not like and subscribe to our channel?