One major decision you’ll have to make when you’re about to buy a home is whether to get a fixed-rate mortgage or an adjustable-rate mortgage (ARM). Let’s look at some of the differences and similarities between the two.
As you may have guessed, there are a few specific differences between ARMs and fixed-rate mortgages. Here’s a quick overview of each type.
Adjustable-rate mortgages are typically 30-year loans, meaning you’ll pay back the money you borrowed over 30 years, with a rate that is fixed for an initial period. An ARM interest rate changes after the fixed period expires.
At the beginning of your loan, you’ll get an introductory rate that’s typically lower than average fixed-mortgage interest rates. The low rate will stay the same for a certain period of time, with the common types being 7 and 10 years. After the fixed-rate period ends, your interest rate will adjust up or down based on an index, like the London Interbank Offered Rate (LIBOR).
Mortgage lenders use a special series of number structures to tell you about your adjustable rate loan and interest periods. For example, another common type of ARM is a 5/1 loan. The first number tells you how long the fixed interest rate lasts. The second number tells you how often your interest rate can change. In this case, it changes yearly, but if you see a “6” in place of the “1,” then the rate changes every 6 months once the fixed period is over.
A fixed-rate mortgage has the same interest rate throughout the life of the loan. Your monthly payment of principal and interest won’t change, though your overall payment can, depending on how your taxes and homeowners insurance fluctuate.
A fixed-rate mortgage loan is the most popular type of financing because it’s the most predictable. However, that predictability, or certainty, of a fixed rate comes with a cost. This cost is what makes ARMs attractive to many people who can save a lot of money with a loan that’s not fixed for the full term of the mortgage.
The main difference between a fixed- and an adjustable-rate loan is that the interest rate will never change for a fixed-rate mortgage. On the other hand, an ARM’s interest rate can change multiple times over the loan term. The monthly mortgage payment will change, too, if the index rises and falls.
There are also a few other ways that ARMs and fixed-rate loans are different. Let’s learn more.
Your ARM rate can never fall below a certain margin specified in your loan documentation. For example, if the margin specified is 3%, the margin is added to the current index number on the date your rate adjusts.
ARM loans have rate caps that limit the amount your interest rate can rise or drop in a single period and over the lifetime of your loan. Your loan might not increase or decrease exactly along with the market if it hits its cap.
An initial cap is the maximum percentage your rate can increase or decrease in a single period after your fixed-rate period expires. A periodic cap limits the maximum amount that an interest rate can change from one adjustment period to the next.
A lifetime cap puts a limit on the total amount that your interest rate can increase or decrease from the introductory rate over the mortgage term. Your lender will express your ARM caps as a series of three numbers separated by forward slashes in this format: initial cap/periodic cap/lifetime cap. This is your “cap structure.”
So, an ARM with a 2/1/5 cap structure means that your loan can increase or fall 2% during your first adjustment and up to 1% with every periodic adjustment after that. Finally, your interest rate can’t increase or decrease more than 5% above or below the initial rate over the entire lifetime of your home loan.
Interest rates for ARMs are lower than fixed-rate loans, at least for a few years. Lenders usually charge a higher interest rate for fixed-rate loans because they must predict interest changes over time. Because an ARM’s rate changes to fit the market, lenders can be more lenient with initial loan charges and give you a lower mortgage rate to begin with.
When you apply for a mortgage, your lender looks at how much income your household brings in a month versus how much you spend each month. This is your debt-to-income (DTI) ratio, and it’s a major factor when you get a loan. If you have a slightly higher DTI ratio, you may have an easier time qualifying for an ARM than a fixed-rate mortgage.