One of the key decisions to make during the mortgage search process is choosing between a fixed-rate mortgage and an adjustable-rate mortgage (ARM).
There are trade-offs between the two. Fixed rates provide the security of a known payment. ARMs typically offer a lower initial rate and can benefit from decreasing rate environments.
A fixed-rate is an interest rate that doesn't change. These mortgages often have a 15- or 30-year term. For the duration of that term, fixed-rate mortgages let you pay the same principle and interest amount each month. Fixed-rate mortgages typically have higher initial interest rates than ARMs, which may limit the price of the home you can afford.
Adjustable-rate mortgages (or ARMs) have interest rates that change over time. Depending on the product, the rate may stay fixed for a few years and then periodically change afterward, according to a defined schedule. For example, a 5/1 ARM, which is the most popular adjustable-rate mortgage, has an introductory rate that lasts for 5 years, and afterward interest rate changes every year (hence the “5/1” sign).
The adjustments have two components: index and margin. The index is a separate underlying interest rate. For a while, the most common index was LIBOR. The margin is the amount of interest you will pay over the index. Your fully indexed interest rate will be your index plus your margin. For example, if your index is trading at 2.5% and your margin is 1%, you will pay 3.5% of interest. However, if your index rate moves to 3.5% the following year, you would be paying 4.5% of interest (3.5% + 1.5%). The index changes year-to-year but the margin typically doesn't change.
Choosing which rate is right for you
We generally recommend choosing a fixed-rate mortgage over an ARM because there is no risk of rate increases in the future. You know exactly what you owe every month and can plan ahead for it. However, there are two main reasons people choose ARMs over fixed-rate mortgages:
You plan to move out after 5 to 10 years: Perhaps you are a first-time homebuyer who plans to buy a bigger house after a few years. Or you have a job that requires you to relocate to a new city every 3 to 4 years. You may want to choose an ARM (with a fixed component) because you can pay lower rates in the early years and move out before the fixed period ends.
You believe rates will go down in the future: If you believe rates will decrease in the future, an ARM can take advantage of the declining rates by letting you adjust every period without needing to refinance.