A fixed rate mortgage locks in your interest rate for the entire loan term, so your interest rate stays the same no matter what happens in the market.
Adjustable mortgage rates, or ARMs, start off with a fixed interest rate for a set period—usually 5, 7, or 10 years—then adjust periodically based on the market. This means your monthly payments can go up or down after the initial fixed-rate period ends.
ARMs are a gamble: you could save money if rates stay low, but you’re taking a risk if they rise.
Adjustable Rate Mortgages (ARMs) can be a double-edged sword. They often start with a lower interest rate compared to Fixed Rate Mortgages, but that rate is like a ticking time bomb—it can change. When the initial fixed period ends, your rate could shoot up, causing your payments to fluctuate. This unpredictability can mess with your budget and long-term financial plans.
Now, you could dodge this in theory by refinancing if rates are lower in the meantime, but there’s additional costs associated with any kind of refinance. While some lenders promise a “free refinance,” what they’re really talking about is a refinance with “no added lender fees” (which they really shouldn’t charge in the first place). There’s still plenty of closing costs associated with any kind of refinance, so it’s not an easy out if rates suddenly spike.
Let’s break it down…
For a home priced at $450,000 with a 10% down payment ($45,000), the loan amount would be $405,000. The initial fixed-rate mortgage is set at 6.5%, while the starting rate for an ARM is 5.0%.
When things go your way (rates drop)
- Initial ARM Rate: 5.0%
- Initial Fixed Rate: 6.5%
Initial monthly payments:
- ARM: $2,176
- Fixed Rate: $2,558
After 5 Years:
- ARM Rate drops: Let’s say rates fall and your new ARM rate is 4.0%.
- New monthly payment: $1,936
Outcome: You started off saving $382 per month with the ARM, and now, you’re saving even more with the lower rate. Your payment drops to $1,936, which could mean more cash in your pocket each month.
When things take a turn for the worse (rates rise)
- Initial ARM Rate: 5.0%
- Initial Fixed Rate: 6.5%
Initial monthly payments:
- ARM: $2,176
- Fixed Rate: $2,558
After 5 Years:
- ARM Rate Rises: Imagine rates go up and your new ARM rate is 8.0%.
- New Monthly Payment: $2,978
Outcome: You started off saving $382 per month with the ARM, but now your payment has jumped to $2,978. That’s a whopping $420 more than if you had stuck with the fixed rate. This spike could hit your budget hard and make future planning a headache.
What are the pros and cons of each?
| Mortgage Type | Pros | Cons |
| Adjustable Rate Mortgages (ARMs) | Lower initial rates mean lower early monthly payments. Potential for savings if interest rates remain stable or decline. Possibly lower costs in the early years. | Rate increases after the initial fixed period can lead to higher payments. Monthly payments can fluctuate, making budgeting harder. Payment jumps may occur despite caps and limits. |
| Fixed Rate Mortgages | Consistent interest rate and monthly payments throughout the loan term. Predictable payments make budgeting easier. Stable long-term planning with no surprises. | Higher initial rates compared to ARMs. Less flexibility if interest rates fall, requiring refinancing to benefit from lower rates. Potentially higher overall costs if rates drop or remain low. |
Do most borrowers choose a fixed rate or adjustable mortgage rate?
At Tomo Mortgage, we’re steering clear of ARMs right now. The fixed-rate mortgages are coming out ahead in terms of pricing, so it’s a no-brainer for most of our clients. While ARMs might get some interest, the stability and better rates of fixed mortgages are making them the go-to choice these days.
Who can ARMs be a good fit for?
Here’s when an ARM might be worth considering if things were different: If you’re planning to move or sell your home within the next 5-7 years, an ARM could offer lower initial rates and potential savings during that period. If you’re flexible with your budget and can handle some rate fluctuations, an ARM might be appealing. Finally, if you’re comfortable with a bit of financial risk and believe rates will remain stable or decrease, an ARM could be a viable option.
Will I pay more interest with an ARM or a fixed-rate mortgage?
ARMs might offer lower interest payments due to their lower initial rates. However, if interest rates rise significantly during the life of the loan, you could end up paying more in total interest compared to a fixed-rate mortgage. Fixed-rate mortgages provide stability and predictable costs, which can be beneficial if you plan to stay in your home long-term.
How often can the rate on an ARM change?
With an ARM, the frequency of rate changes depends on your specific ARM type. For instance, a 7/1 ARM locks in your rate for the first 7 years, then starts adjusting annually. A 5/1 ARM has a similar setup but changes every year after 5 years.
The key thing to remember is that during the initial fixed period, your rate is stable. Once that period ends, the rate starts adjusting based on an index plus a margin. So, with a 7/1 ARM, you’re safe for 7 years, but after that, expect your rate—and your payments—to fluctuate annually.
What’s the impact of inflation on fixed-rate mortgages?
If you’re locked into a fixed-rate mortgage, and the Fed moves to increase interest rates to control inflation, you’re sitting pretty compared to those with variable rates who face higher payments. Essentially, you’re benefiting from the fact that your cost of borrowing was set at a lower rate before rates began to rise.
What should I consider if I plan to sell my home before the ARM rate adjusts?
First, check the remaining time on your ARM’s initial fixed-rate period. Selling before this period ends can help you avoid potential rate increases. Keep an eye on the housing market; a strong market could lead to a quicker sale and a better price, which can help offset any future rate hikes. Be aware of prepayment penalties, as some ARMs include these fees if you pay off the loan early—so review your loan terms closely.
Are there penalties for paying off an ARM early?
Yes, there can be penalties for paying off an ARM (Adjustable-Rate Mortgage) early. These prepayment penalties compensate lenders for the interest they miss out on if you pay off your loan before its term ends. The penalty amount can vary and might be a percentage of the remaining loan balance or a set number of months’ worth of interest. It’s crucial to review your loan agreement to understand if and how these penalties apply.
The penalty usually applies during a specific period, often the first few years of the loan. If you plan to refinance or sell your home, this could affect your decision.
If you’re ready to start your journey to homeownership, get pre approved with Tomo Mortgage today.
