Fixed-Rate vs. Adjustable-Rate Mortgage
Understand how fixed-rate and adjustable-rate mortgages differ, with a worked example of how an ARM payment can change.
The short version
A fixed-rate mortgage keeps the same interest rate, and therefore the same principal-and-interest payment, for the whole loan. An adjustable-rate mortgage (ARM) starts with a fixed rate for a set period and then adjusts periodically. ARMs often start with a lower rate, but your payment can rise later.
How an ARM is described
You will often see ARMs written as "5/1" or "7/1". The first number is how many years the starting rate is fixed. The second number is how often the rate can change after that (every 1 year, in this case). After the fixed period, the new rate is usually based on a market index plus a margin set by the lender.
ARMs also have caps, which limit how much the rate can rise at the first adjustment, at each later adjustment, and over the life of the loan. Always ask for these numbers in writing.
A worked example
Take a $300,000 loan over 30 years. These rates are illustrative.
- Fixed at 6.5%: monthly principal and interest of about $1,896 for the whole loan.
- 5/1 ARM starting at 5.5%: about $1,703 per month for the first five years.
The ARM saves about $193 per month, or roughly $11,600 over five years. But after five years you would still owe about $277,400. If the rate then adjusts to 7.5% for the remaining 25 years, the payment would become about $2,050, which is about $347 more than before and about $154 more than the fixed-rate payment.
If instead the rate stayed at 5.5% or fell, the ARM would have cost less. The risk is that you cannot know in advance.
When a fixed-rate loan may fit better
- You plan to stay in the home for many years.
- You want a predictable payment and a simple budget.
- Your budget would be stretched by a payment increase.
When an ARM may be worth considering
- You expect to sell or refinance before the fixed period ends.
- You can comfortably afford the highest payment the caps would allow.
- The initial savings are large enough to matter and you have a plan for the savings.
Questions to ask a lender
- How long is the initial fixed period?
- Which index and margin will be used after that?
- What are the first-adjustment, periodic and lifetime caps?
- What would my payment be if the rate rose to the maximum?
- Are there prepayment penalties if I refinance or sell?
Frequently asked questions
Can I refinance an ARM into a fixed-rate loan?
Usually you can apply, but approval and the new rate depend on market conditions, your credit and your home's value at that time. Refinancing also has closing costs, so do not assume it will always be possible or cheap.
Is an ARM always riskier?
It carries more payment uncertainty after the fixed period. Whether that is acceptable depends on your finances, your time horizon and the loan's caps.
Do these payments include taxes and insurance?
No. The examples show principal and interest only. Property taxes, homeowners insurance and any mortgage insurance are additional.
Try it yourself
Use our mortgage calculator to compare different interest rates and terms for your own loan amount, and test what a higher rate would do to your payment.
This guide is for educational purposes only and is not financial, tax, or legal advice.