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What’s the difference between an ARM and a fixed-rate mortgage?

The fundamental difference is in how interest rates are structured, affecting monthly payments and long-term costs.

• Fixed-rate mortgages lock in an interest rate for the life of the loan, typically from fifteen to thirty years. During that time, monthly interest and principal payments never change. Fixed-rate mortgages often start at higher rates than ARMs. Depending on market conditions, you could pay more or less overall interest compared to an ARM.
• With an adjustable-rate mortgage, your initial monthly payments are usually lower than with a fixed-rate mortgage. This makes ARMs more affordable in the short term and more uncertain in the long term.

If interest rates decrease, fixed-rate mortgage holders often refinance to a lower rate. Refinancing typically costs between 2% and 6% of the loan amount. People with ARMs, however, will often see their monthly payments lower automatically.

Who should consider an adjustable mortgage rate?

For some people, ARMs can be the smartest financial move. Adjustable-rate mortgages work best for these types of homebuyers:

• Short-term homeowners. If you plan to sell your home within five to seven years, taking advantage of an ARM’s low introductory rate could save you significant money. People who buy starter homes or have jobs that require moving, such as military families or corporate transferees, often choose ARMs.
• People who refinance. Switching to a fixed-rate mortgage when the initial ARM rate ends could make financial sense. This depends on market conditions you can’t predict and refinancing costs that can fluctuate.
• The upwardly mobile. If you’re confident your income will significantly rise, the lower initial monthly payments of an ARM might make sense. This could be true if you’re expecting a windfall, such as an inheritance or the sale of an asset.
• Investors. House flippers and other real estate investors typically prefer adjustable-rate mortgages; these investors often upgrade and sell a home long before an ARM’s initial interest rate expires.

Risk tolerance matters. The uncertainty of an ARM can come with some level of anxiety. For some borrowers, a fixed-rate mortgage that offers more peace of mind is best. If you’re more comfortable with risk and in a good financial position to weather market changes, an ARM may be the better choice.

Advantages of an Adjustable-Rate Mortgage

• Low Introductory Costs. Lower initial interest rates (often called teaser rates) mean early-year savings, making ARMs short-term budget-friendly compared to fixed-rate mortgages.
• Savings Potential. If market conditions go in your favor, your monthly payments will fall. While you can’t predict the future, the past indicates that borrowers with ARMs can pay less overall interest compared to those with fixed-rate mortgages. However, rates could also rise.
• Purchasing Power. An ARM could qualify you for a larger loan than you might get with a fixed-rate mortgage. That could allow you to buy a more expensive home.
• More Cash Flow. If your monthly mortgage payments are lower, you’ve got more cash in hand each month. These funds could go towards other goals, such as home improvements, savings, or paying down credit cards.
• Rate and Payment Caps. ARMs don’t have the surety of fixed-rate mortgages. However, initial, subsequent, and lifetime caps tell you how much your interest rate and monthly payments can rise over the year and the loan’s lifetime.
• No Refinancing Needed. Unlike fixed mortgages, ARMs adjust automatically when rates fall. This can save you money; an average refinancing can cost between $5,000 and $15,000.

Disadvantages of an Adjustable-Rate Mortgage

• Unpredictability. After the fixed-rate period ends, you won’t know exactly how much your monthly payments will be over the coming years. You may have to adjust your budgeting to match the ebbs and flows of the market.
• Complexity. Fixed-rate mortgages are more straightforward. ARMs involve tracking multiple rate caps, adjustment schedules, and market indexes. This complexity can be daunting for first-time borrowers.
• Negative Amortization Risk. With payment-option ARMs, you could run the risk of negative amortization. This is when minimum payments don’t cover the full interest and the loan balance increases over time.
• Payment Shock. Even though you’re expecting the initial low payment period to end, payment jumps of hundreds of dollars can strain your budget and give you stress.

Still unsure whether an ARM is right for you? Speak with an Equinox mortgage expert at 1-888-505-8960 or connect with us online.