Fixed or adjustable-rate mortgage, how to choose
Most advice on this question tries to predict where rates are heading, and no one knows that for sure. A more useful question is: how much risk can you carry, and what are you willing to pay to avoid it?
The two options
- Fixed-rate mortgage: your rate stays the same for the whole loan, so your principal and interest payment never changes. If rates fall, you only benefit by refinancing, which has its own costs.
- Adjustable-rate mortgage (ARM): your rate is fixed for an initial period, then moves with a market index plus a margin. A 5/6 ARM, for example, is fixed for 5 years and then adjusts every 6 months.
ARMs usually start at a lower rate than fixed loans, though not always. That initial discount is what you get in exchange for taking on the risk of future increases.
Run a stress test
Calculate your payment at today’s rate and at a much higher one. For a $300,000 loan over 30 years, principal and interest only:
| Rate | Monthly payment | Difference from 6% |
|---|---|---|
| 5% | $1,610.46 | −$188.19 |
| 6% | $1,798.65 | — |
| 7% | $1,995.91 | +$197.26 |
| 8% | $2,201.29 | +$402.64 |
| 9% | $2,413.87 | +$615.22 |
Now compare it with your income. If your household takes home $6,500 a month, a $1,799 payment is about 28%. At 8% it rises to nearly 34%, and at 9% to 37%, before property tax and insurance.
If the high case would mean you could no longer save or would have to cut essentials, the ARM carries a real risk for you. This table simplifies things a little, because an ARM adjusts on your remaining balance and term, but the size of the jump is what matters. Try your own numbers in the mortgage calculator.
What you pay for peace of mind
Think of the rate gap as an insurance premium. Say an ARM starts at 5% and a fixed loan is at 6%. You save $188 a month, or about $2,258 a year. Over a 5-year initial period, that is about $11,300, plus somewhat faster paydown.
If the ARM later jumps to 8%, you would pay about $403 more a month than on the fixed loan. It would take roughly 28 months at that level to lose what you saved. So the ARM does not lose instantly, and if you sell or refinance before then, it could clearly win. If you stay for 30 years and rates stay high, it could cost you far more.
Know the ARM’s limits
Before you sign, find out these details from your Loan Estimate:
- Initial period: how long the rate is fixed.
- Index and margin: your future rate equals the index plus the margin. The margin never changes.
- Caps: the maximum increase at the first adjustment, at each later adjustment and over the life of the loan.
- Worst-case payment: calculate your payment at the lifetime cap. That is the number to plan around.
Five questions to help you decide
1. How long will you keep the home? This matters most. If you are confident you will move within the fixed period, an ARM can make sense. Plans do change, though, so have a fallback.
2. How much room is in your budget? The less slack you have, the more a stable payment is worth.
3. How steady is your income? Two stable salaries absorb a rate rise better than variable or freelance income.
4. Could you refinance if you had to? Refinancing requires equity, good credit and fees. It is not guaranteed when you need it, for example if home values fall or you lose your job.
5. How would it feel? If each adjustment date would cost you sleep, that counts too.
How to compare offers
- Compare APRs carefully. An ARM’s APR relies on assumptions about future rates, so it is not directly comparable with a fixed loan’s.
- Look at points and fees alongside the rate.
- Check for prepayment penalties in case you decide to pay extra or pay it off early.
- Get several quotes. Rates and fees for the same borrower can vary across lenders.
Not a decision for life
You can refinance a loan, and an emergency fund gives you time to react if payments rise. This article is general information, not personal advice. For more background, see the Consumer Financial Protection Bureau.