What is the difference between adjustable-rate and fixed-rate mortgages?

As the economy begins to open back up from the COVID-19 pandemic, recent reports show that homebuyers are heading back to the housing market as mortgage rates hit a record-low. The fall in U.S. mortgages rates has led to the highest level of purchase application in more than a decade. While the demand is on the rise for mortgages, here are a few things to keep in mind.

Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the interest rate and monthly payments fluctuate as market interest rates change. Most ARMs have a fixed-rate period at the beginning, during which the interest rate does not change, followed by a longer period where the rate changes at predetermined intervals.

The interest rates of adjustable-rate mortgages generally start lower than comparable fixed-rate mortgages in order to attract customers enough to assume the risk of higher future rates. The initial fixed-rate period of an ARM can range from one month to ten years. Historically, the most common type of ARMs were one-year ARMs, which have a fixed rate for the first year and a rate that adjusts annually thereafter. A more common ARM currently is the 5/1 ARM, which has a fixed-rate period of five years and an annually adjusted rate subsequently. When a relatively long fixed period is mixed with an even longer adjustable period, it is known as a hybrid. The fluctuation of the adjustable rate is determined by an index that is outlined in the particular mortgage terms. The lender determines the index value and adds a margin to calculate the borrowers new rate for each adjustment.

The low initial rates of ARMs can be very appealing, but there is a degree of uncertainty associated with the adjustable period. Having an adjustable-rate mortgage allows borrowers to take advantage of falling rates during the adjustable period without refinancing. By the same token, however, borrowers are also subject to rising rates. ARMs can also be difficult to understand for some borrowers, as lenders have the flexibility to determine margins, caps, adjustment indexes.

Fixed-rate mortgages feature static interest rates and monthly payments, generally for 15 or 30 year periods. With a fixed-rate mortgage, your house payment will not rise and fall with interest rates and when rates are low, fixed-rate mortgages can be very affordable.

Fixed-rate mortgages have the benefit of a constant rate and payments. Even if inflation increases dramatically, the rate will remain the same. Budgeting is easier to determine, as the borrower’s housing cost will not fluctuate and fixed rate mortgages are easier to understand than ARMs.

However, in the case that interest rates decrease, a borrower with a fixed-rate mortgage would have to refinance in order to take advantage of the lower rates. This means closing costs, working with the title company, and hours spent gathering and filling out forms. In a high rate period, fixed-rate mortgages can be more unaffordable than ARMs, since borrowers don’t have an initial lower rate period.

When deciding on the type of mortgage to pick, some things to consider are how long you plan on owning the home, how frequently the ARM adjusts, the current rate environment, and if you could afford the monthly payment if interest rates were to rise significantly. If you are only planning to keep the house for a few years, a lower rate 3/1 or 5/1 ARM priced 3/1 or 5/1 might be a good option. After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage; however some adjust as frequently as every month. If this much instability is a concern, a fixed-rate mortgage is the better option. When interest rates are higher, ARMs, with their lower rates in the initial period can be a good option. However, when rates are lower, a fixed-rate mortgage makes more sense.