Understanding Mortgages: Fixed Rate vs. Adjustable Rate

Nov 8, 2023

If you’re like most people, your home is one of the biggest investments you’ll ever make. Buying a house can help you secure your financial future and set you up for a worry-free (and mortgage-free) retirement.

If you’re in the market for a new home or mortgage, you’ll likely have to decide between an adjustable vs fixed-rate mortgage. Determining which is better for your situation requires having a solid understanding of each type of mortgage. Let’s look at the similarities and differences to have all the information you need to compare fixed-rate vs. adjustable-rate mortgages.

Fixed-Rate Mortgages

As the name implies, a fixed-rate mortgage is a mortgage loan where the interest rate stays the same for the life of the loan. This also means your monthly payment on the principal and interest will remain the same over the entire course of the loan. And you’ll never have to worry about the rising and falling of interest rates in the larger economy (at least not as far as your mortgage is concerned).

How Fixed-Rate Mortgages Work

Some of the appeal of a fixed-rate mortgage is in the simplicity. Many lenders offer them in standard lengths, the most common being 30-year and 15-year terms. When you enter into a fixed-rate mortgage, you know how much you’ll be paying each month on your mortgage and how long you’ll be making those payments.

Note that the above statement applies to the principal balance and interest payments you make each month. Most mortgages also roll the costs of homeowners insurance and property taxes into your monthly mortgage payment. Those costs are subject to change over the life of your mortgage loan (regardless of whether you have a fixed rate vs adjustable rate mortgage).

Benefits of Fixed-Rate Mortgages

Fixed-rate mortgages are ideal for predictable budgeting, locking in favorable interest rates, and comparison shopping.

Predictable budgeting

When you take out a fixed-rate mortgage, you know how long your loan will last and how much you’ll pay each month toward your principal balance and interest costs. This makes it relatively easy to budget for your mortgage. Each month, you know that a certain amount of your earnings will be used for your mortgage payment. And you don’t have to worry about that amount taking a drastic swing.

Locking in low-interest rates

Choosing a fixed-rate mortgage can save you substantial money if you’re buying a home and shopping for a mortgage when interest rates are low. A difference of a few percentage points can mean tens or even hundreds of thousands of dollars of savings over the course of a 30-year fixed-rate mortgage.

Because benchmark interest rates fluctuate due to larger economic forces, the mortgage rates when you’re ready to buy a home are completely out of your control. But if you can lock in a low fixed rate, it can save you quite a bit over the life of your mortgage.

You’ll also have protection against rising interest rates.

Comparison shopping

Comparing different mortgage loan options from different lenders can be overwhelming. You’ll need to consider everything from rates and terms to fees and closing costs. But fixed-rate mortgages are simpler to compare to one another, if only because they have fewer moving parts than adjustable-rate mortgages. You don’t have to worry about introductory rates or trying to predict how interest rates will move.

Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) comes with an interest rate that changes over the course of your mortgage loan. An ARM will typically start off with a fixed interest rate for a certain amount of time. That interest rate will reset after the initial period (and possibly continue to reset at regular intervals). The new interest rate will be based on market conditions (and, therefore, could go up or down).

Most ARMs have their rates tied to independent benchmarks, such as the yield on a one-year Treasury bill. When your interest rate resets, the new rate will be based on that benchmark.

How ARMs Work: Key Terms

An adjustable-rate mortgage is less straightforward than a fixed-rate mortgage, so there is some important terminology that is helpful to understand.

Fixed period

ARMs usually start off with a fixed period of time during which the interest rate does not change (this interest rate is sometimes known as the intro rate). The intro rate is typically on the lower side, meaning that your mortgage payments will usually be quite affordable during this fixed period.

The fixed period for an ARM varies but usually ranges between three and ten years.

Adjustment frequency

The interest rate on your mortgage will be adjusted periodically once the fixed period of the ARM has ended. The adjustment frequency refers to how often the interest rate on your mortgage will change. A one-year ARM would adjust every year, while the rate on a three-year ARM would change every three years.

The fixed period and adjustment frequency are often noted in the name of the ARM. For example, a 5/1 ARM would mean a mortgage with a five-year fixed period and an adjustment frequency of one year. A 7/6m ARM would be a mortgage with a seven-year fixed period and an adjustment frequency of six months.

Adjustment Cap (or Rate Cap)

Most ARMs will include a ceiling for how high your mortgage interest rate could rise. There may be a maximum your interest rate can rise per adjustment, as well as a ceiling for how high the rate could go during the life of the loan.

Similarly, some ARMs also include adjustment floors to limit how low your loan interest rate could fall.

Pros and Cons of ARMs

The primary benefit of adjustable-rate mortgages is that they often have low starting rates. Lower interest rates mean lower monthly mortgage payments, choosing an ARM could be a way to afford mortgage payments on a more valuable property.

If you’re quite confident that your income or financial situation will be changing for the better shortly, choosing an ARM can allow you to afford a more expensive home now, with the expectation that you’ll be able to afford a larger monthly mortgage payment. It can also be a good option if you plan to sell your home before the interest rate on your loan adjusts.

The downside of an ARM is that your mortgage payments may rise significantly at the end of your fixed period. If you had plans to move or refinance before your mortgage adjusts, but those plans don’t come to fruition, you could end up stuck with unaffordable monthly payments.

Comparing Fixed-Rate vs. Adjustable Rate Mortgages

The amount of risk is the primary difference between an adjustable vs. a fixed-rate mortgage. With a fixed-rate mortgage, you know exactly what you’re getting from the outset. Your monthly mortgage payments will be predictable and consistent.

When you take an adjustable-rate mortgage, it’s typically because you have a plan to sell your home, pay off your loan, or refinance your mortgage before the rate resetting.

Interest Rates & Payments

Initial interest rates on ARMs are typically lower than rates on fixed mortgages. These initial ARM rates are sometimes called “teaser” rates, as the discount makes them attractive.

It is important to note that interest rates on an ARM could also go down following the fixed period. If you are buying a home with high interest rates, you may be willing to take the chance that rates will come down by the time the introductory fixed period on your loan has ended.

Risk Factors

Fixed-rate mortgages are almost always a less risky proposition than adjustable-rate mortgages. A fixed-rate mortgage offers predictability over the life of the loan — you understand at the outset what your monthly payments will be going forward. However, that doesn’t mean a fixed-rate mortgage is risk-free. When you take a fixed-rate mortgage, you’re giving up the chance to take advantage of the introductory period of an ARM — when you’d likely have lower interest rates and monthly payments.

Rising interest rates are the primary risk factor to consider when signing up for an ARM. The interest rate market, like all markets, is unpredictable. If rates are higher when your introductory period ends, your monthly mortgage payments will also rise.

Qualifying for a Mortgage

In order to qualify for a mortgage, potential lenders will evaluate your ability and likelihood to pay back the mortgage loan. Most lenders will consider factors such as your income, credit score, total assets, and total debts when deciding whether or not to approve you for a mortgage loan. Lenders will also consider the property you’re seeking to buy, including whether you’re looking to finance a home as your primary residence or buying a second home or an investment property.

Choosing the Right Mortgage for You

The right mortgage for you will be highly dependent on your personal circumstances and your plans for the future. That’s why it’s often extremely helpful to consult with an expert when considering your mortgage options.

For some homebuyers, the certainty of a fixed-rate mortgage provides the security they need to secure their dream home. For others, an adjustable-rate mortgage might offer the perfect amount of flexibility and opportunity.

Let Rob Sturms Help

Buying a home and choosing a mortgage is likely one of the biggest financial decisions you’ll ever have to make. I have been helping Colorado residents with their mortgage questions and needs for the past 30 years.

I meet with each potential homeowner individually, helping you develop a path to homeownership in three simple steps. First, we’ll create a financial snapshot to help you understand what might be financially feasible. Then, we’ll create a mortgage plan personalized to your situation. I’ll guide you on how to optimize your loan options and seek out the loans best suited to your needs. Finally, I’ll walk you through the entire mortgage process, from pre-approval to closing.

Frequently Asked Questions

What is a 5/5 ARM?

A 5/5 ARM is an adjustable-rate mortgage with a five-year fixed period and an adjustment period of five years. This means the initial interest rate on your mortgage will remain the same for the first five years of your mortgage. After five years, the interest rate will be adjusted, going up or down depending on benchmark rates. The interest rate will continue to be adjusted every five years for the remainder of the loan.

What Is a Hybrid ARM?

A hybrid ARM includes both a fixed interest rate and an adjustable interest rate. Generally, the fixed period will occur at the beginning of the loan, followed by a period where interest rates on the loan are adjustable. This is the standard type of ARM.

What Is an Interest-Only Mortgage?

An interest-only mortgage allows you to pay only the interest on your mortgage loan for a set period of time. This period generally ranges between three and 10 years. During this time, payments you make on your mortgage will not reduce the principal balance you owe on the home.