Fixed vs. Adjustable-Rate Mortgage: What’s the Difference?

Each loan type offers different payment structures and risk levels.

If you're looking for everything you need to know about mortgages, this guide breaks down how fixed-rate and adjustable-rate mortgages (ARMs) work and helps you figure out which one fits your situation best.

Key Takeaways

• Fixed-rate mortgages offer stable payments throughout the entire loan term.
• ARMs typically start with lower rates but can increase over time, depending on market conditions.
• Fixed-rate loans work best for long-term homeowners seeking predictable payments.
• ARMs benefit short-term buyers or those expecting income growth.

Understanding Fixed-Rate Mortgages

A fixed-rate mortgage maintains the same interest rate for the entire loan term. Your monthly mortgage payment stays consistent, making budgeting easier over time.

Fixed-rate mortgages use amortization to structure payments. Early payments work mostly towards interest, while later payments focus on principal reduction. This continues until the loan is fully paid off.

Common Fixed-Rate Mortgage Terms

The three most common fixed-rate mortgage terms offer different payment structures:

1. 30-year mortgages: 30-year mortgage lenders offer lower monthly payments but higher total interest costs.
2. 20-year mortgages: Moderate payments with balanced interest savings.
3. 15-year mortgages: Higher monthly payments but significant interest savings.

Shorter terms typically offer lower interest rates. For example, a 15-year mortgage might have rates 0.25% to 0.75% lower than 30-year loans.

How Fixed-Rate Amortization Works

Amortization spreads loan payments equally across the entire term. Each payment includes both principal and interest portions. Early payments contain more interest while later payments reduce more principal.

For example, on a $300,000 loan at 6% interest, the first payment might include $500 toward principal and $1,500 toward interest. The final payment reverses this ratio.

Economic Factors Affecting Fixed Rates

• 10-Year Treasury yields: Mortgage rates closely follow Treasury bond movements.
• Federal Reserve rates: Higher Fed-raised interest rates typically push mortgage rates up.
• Inflation levels: Rising inflation often leads to higher interest rates.
• Economic growth: Strong growth can increase rates while weakness lowers them.

Understanding Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) features interest rates that change over time. ARMs typically start with lower rates than fixed mortgages, but can increase or decrease based on market conditions.

Your monthly payment changes when the interest rate adjusts. This creates payment uncertainty but offers potential savings if rates remain low.

Common ARM Structures

• 5/1 ARM: Fixed rate for 5 years, then adjusts annually.
• 7/1 ARM: Fixed rate for 7 years, then adjusts annually.
• 10/1 ARM: Fixed rate for 10 years, then adjusts annually.
• 3/1 ARM: Fixed rate for 3 years, then adjusts annually.

The first number shows the fixed-rate period. The second number indicates the adjustment frequency after that period.

ARM Components

Three key components determine how ARMs function:

1. Index: A market rate that changes over time and affects your mortgage rate.
2. Margin: A fixed percentage added to the index to determine your final rate.
3. Adjustment caps: Limits on how much rates can increase at each adjustment or over the loan's lifetime.

Together, these components control how high or low your payments fluctuate during rate adjustments.

ARM Rate Caps

Three types of caps protect borrowers from excessive rate increases:

• Initial cap: Limits the first rate change, typically 2% to 5%.
• Periodic cap: Limits subsequent changes, usually 1% to 2% per adjustment.
• Lifetime cap: Maximum total increase, typically 5% to 6% above the starting rate.

These caps prevent extreme payment shock during market volatility.

Fixed vs ARM Mortgages: Pros and Cons

Fixed-Rate Mortgage Advantages

• Payment stability: Monthly payments never change, making budgeting simple and predictable.
• Interest rate protection: You're protected from rising market rates throughout the loan term.
• Long-term planning: Easy to calculate total interest costs and plan financial goals.
• Simple structure: No complex rate adjustment mechanisms to understand or track.
• Peace of mind: No surprises or payment increases regardless of market conditions.

Fixed-Rate Mortgage Disadvantages

• Higher starting rates: Initial rates typically exceed ARM starting rates by 0.5% to 1%.
• Limited flexibility: Cannot benefit from falling rates without refinancing.
• Higher monthly payments: Early payments can be larger than comparable ARM payments.
• Refinancing costs: Must pay closing costs to access lower rates if they become available.

ARM Advantages

• Lower initial rates: Starting rates typically run 0.5% to 1% below fixed-rate mortgages.
• Reduced early payments: Lower monthly payments during the initial fixed period.
• Rate decrease potential: Payments can drop if market rates fall during adjustment periods.
• Short-term savings: Ideal for borrowers planning to sell or refinance before rate adjustments.

ARM Disadvantages

• Payment uncertainty: Monthly payments can increase unexpectedly after adjustment periods.
• Rate increase risk: Interest rates may rise substantially over time based on market conditions.
• Budgeting challenges: Changing payments make long-term financial planning difficult.
• Potential higher costs: Total interest payments may exceed fixed-rate mortgages if rates rise.

Choosing Between Fixed and Adjustable Rate Mortgages

When Fixed-Rate Mortgages Work Best

• Long-term homeowners: If you’ll be in the home for 7+ years, locking in a fixed rate helps you avoid future market fluctuations.
• Budget-conscious buyers: If you need consistent monthly payments to stay on top of your finances, a fixed rate gives you reliable stability.
• Risk-averse borrowers: If you prefer predictability over potential savings, fixed payments offer peace of mind with no surprises.
• First-time homebuyers: If you’re new to homeownership, a fixed-rate loan keeps things simple and easy to manage without worrying about adjustments.
• Tight budget situations: If your finances can't stretch to cover future increases, locking in your rate protects your monthly budget.

When ARMs Make More Sense

• Short-term homeowners: If you plan to sell or move within 5–7 years, an ARM lets you benefit from lower rates before adjustments begin.
• Income growth expectations: If you expect your salary to rise, you’ll be better positioned to handle potential rate increases down the line.
• Lower payment needs: If you need to keep costs down at the start, ARMs typically offer lower initial payments than fixed-rate loans.
• Risk-tolerant borrowers: If you’re comfortable with some uncertainty, an ARM gives you the chance to save money upfront.
• Refinancing plans: If you know you’ll refinance before the rate adjusts, an ARM can provide early savings without long-term risk.

Market Condition Considerations

Different market environments affect the fixed versus ARM decision:

• Rising-rate markets: Fixed-rate mortgages protect from increasing costs while ARMs become more expensive over time.
• Falling-rate markets: ARMs allow borrowers to benefit from decreasing rates while fixed-rate borrowers must refinance to access savings.
• Stable rate markets: Either option works well, but fixed rates offer predictability while ARMs may provide modest initial savings.

Questions to Ask Before Choosing a Mortgage Type

You will need to ask yourself a few questions when choosing between mortgage types, including:

• How long do I plan to stay in this home?
• Can I handle possible monthly payment increases?
• Do I prioritize payment stability or lower initial costs?
• Am I comfortable with refinancing if market conditions change?

Once you’ve decided on the best route for your situation, you will then need to ask your mortgage lender a few questions so that they can provide expert insights to help confirm that you’re making the right choice. This includes:

• What are the potential long-term costs associated with the mortgage option, including rate adjustments?
• Explain how market changes could affect monthly payments in the future.
• What are the options for refinancing if you need to adjust your mortgage in a few years?

Switching Between Mortgage Types

Refinancing from ARM to Fixed-Rate

• Review current ARM terms: Understand when your next rate adjustment occurs and potential payment changes.
• Research fixed-rate options: Compare current fixed rates with your ARM's projected adjustments.
• Apply before adjustment: Submit refinancing applications before your ARM's rate adjustment to avoid higher payments.
• Complete home appraisal: Most lenders require updated property valuations for refinancing.
• Close the new loan: Finalize the fixed-rate mortgage and begin making stable monthly payments.

Timing is important when refinancing from ARMs. Apply several months before your adjustment date to ensure closing before the rate increases.

Refinancing Costs to Consider

• Application fees: $75 to $300 for processing loan applications.
• Appraisal costs: $300 to $500 for professional property valuations.
• Title services: $300 to $2,000 for title searches and insurance.
• Origination fees: 0.5% to 1.5% of the loan amount for lender processing.

Total closing costs typically range from 2% to 5% of your loan amount. Calculate whether long-term savings justify these upfront expenses.

When Fixed to ARM Refinancing Makes Sense

• Short-term housing plans: You plan to sell or move within a few years and want lower payments.
• Expected rate decreases: Interest rates are high but projected to fall in the coming years.
• Cash flow needs: You need lower monthly payments and can handle potential future increases.

This strategy requires careful analysis of market conditions and personal financial flexibility.

Conclusion

When weighing a fixed vs adjustable rate mortgage, the right choice depends on your financial goals, market outlook, and personal situation. Fixed-rate mortgages offer long-term payment stability, while ARMs provide lower initial costs but come with future rate uncertainty.

Key factors to consider when choosing a mortgage include how long you plan to stay in the home, your ability to handle payment changes, and your comfort with financial risk. Both mortgage types can support different strategies; it all comes down to what fits your needs best.

Frequently Asked Questions

1. What is the main difference between a fixed-rate and an adjustable-rate mortgage (ARM)?

A fixed-rate mortgage keeps the same interest rate for the life of the loan, so your monthly principal and interest payments stay consistent.

An adjustable-rate mortgage (ARM) starts with a lower fixed rate for an initial period, then adjusts periodically based on market conditions.

2. Which type of mortgage is better for first-time homebuyers?

If you value predictability and stability, a fixed-rate mortgage may be better since your payment won’t change. However, if you plan to sell or refinance within a few years, an ARM might save you money with its lower introductory rate.

3. How often can the interest rate change with an ARM?

It depends on the loan terms. Most ARMs adjust annually after the initial fixed period, but some adjust every six months or at other intervals. Your lender will specify the adjustment schedule.