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

Whether you’re preparing to buy your first home or planning an upgrade or relocation, you have some decisions to make about what type of mortgage you will use. As you shop for the best interest rates and lenders, think about how long you want to have to repay your mortgage and consider the differences between an adjustable-rate mortgage vs. fixed-rate mortgage.
At Addition Financial, our experts share valuable insights about the home buying process, and that includes honest discussions about the realities of getting an adjustable-rate mortgage, as well as a fixed-rate mortgage. There are many options out there and we’ve designed this guide to break down the differences so you can make an informed choice.

Table of Contents

1. What is an ARM?
2. What is a fixed-rate loan?
3. What are the differences between ARMs and fixed-rate mortgages?
4. Can you refinance an ARM to a fixed-rate mortgage?

What is an ARM?

An adjustable-rate mortgage, or ARM, is a type of mortgage where the interest rate is subject to change over the course of the loan term. These mortgages typically come with a low introductory interest rate that remains fixed for a specified period. After that, it is subject to regular adjustments.

What are typical ARM terms?

The introductory period of an adjustable-rate mortgage is described with two numbers. The first number corresponds to the length of time of the initial period, during which your interest rate will be locked in at the introductory rate. The second number indicates how often your mortgage interest rate may be adjusted after the initial period.

One of the most common types of ARM is a 5/1 mortgage. With this type of mortgage, you’ll have a fixed rate period of five years, during which you’ll pay the lower initial interest rate described in your loan agreement. After that, your interest rate may be adjusted once per year. Right now, Additional Financial is offering a 5/6 ARM at a great rate.

Is there a limit on how much my interest can be increased?

Many ARM loans come with caps that limit how much your interest can be increased. There are three types of caps that may come into play, as follows:

• The initial cap limits how much your interest rate may be increased at the end of the initial period.
• The periodic cap limits how much your interest rate may be increased in each adjustment period.
• The lifetime cap sets limits for how much your interest rate can increase (or decrease) over the lifetime of your loan.

At Addition, rates are capped at a 5% increase above the initial rate with periodic rate increases capped at 1% per adjustment period, or 2% per year, or the remainder of your loan terms. This structure will shield you by providing a lifetime increase cap of 5%, meaning that would be the most that your interest could increase over the term of your loan. Keep in mind that some lenders exclude the initial increase from the lifetime cap, so make sure to read carefully before you sign.

What is a fixed-rate loan?

By contrast, a fixed-rate loan is a loan where your lender specifies an interest rate in the loan agreement and that rate remains in place for the entire term of your loan. The interest rate for a fixed-rate loan is typically higher than the introductory rate for an ARM. It’s for that reason that some homeowners choose an ARM over a fixed-rate loan.

With a fixed-rate mortgage, you’ll have the peace of mind of knowing that your interest rate will not change over the lifetime of your loan. You’ll be locked into a consistent monthly payment with no worry that your rate (and monthly mortgage payments) will increase.

What are typical fixed-rate mortgage terms?

Because there are no periodic interest rate adjustments, fixed-rate mortgage terms are simple and easy to understand. Fixed-rate loans are amortized over a specified period. The most common loan term for a fixed-rate mortgage is 30 years, but some homeowners opt for shorter terms of 10, 15 or 20 years. 

If you choose a shorter loan term, you’ll have higher monthly payments than you would with a 30-year term. The benefit is that you’ll pay less interest in the long term.

Do fixed-rate mortgages have balloon payments?

One question that we are sometimes asked is whether a fixed-rate mortgage comes with a balloon payment, a large payment that is due at the end of your loan term. Balloon loans are sometimes referred to as interest-only loans.

If you have an amortized fixed-rate mortgage, you will not have a balloon payment. We recommend against taking out any mortgage with a balloon payment unless you’re confident you’ll have the money to make the final payment, which can add up to tens of thousands of dollars in some circumstances.

What are the differences between ARMs and fixed-rate mortgages?

Now that we’ve outlined the details of adjustable and fixed-rate mortgages, let’s talk about the key differences between ARMs vs. fixed-rate mortgages:

1. Fixed-rate mortgages have predictable payments that remain the same for the entire term of the mortgage, while ARMs have a low introductory rate that can be adjusted after the initial period.
2. Fixed-rate mortgages tend to have higher interest rates when compared with the low introductory rate of ARMs.
3. In some cases, having an ARM makes it possible to take advantage of dropping interest rates. This depends on what it says in your loan agreement, so make sure to read the fine print. With a fixed-rate mortgage, your only option to get a lower interest rate is to refinance your mortgage.
4. You’re likely to pay less in the first few years of an ARM than you would with a fixed-rate mortgage, but you may end up paying significantly more in the long term.
5. There is typically a higher down payment required with an ARM than with a fixed-rate mortgage. It is sometimes possible to get a fixed-rate mortgage with a down payment as low as 3%, but the minimum for an ARM is usually 5%.
6. Debt-to-income ratio requirements may be stricter for ARMs as well because lenders want to make sure you have enough available income to make payments when your interest rate goes up.

It’s essential to understand these differences before you decide which type of mortgage to get. You should not take out an adjustable-rate mortgage unless you have enough income to make higher payments when the initial period ends.

Can you refinance an ARM to a fixed-rate mortgage?

One of the questions we hear most frequently is about the possibility of refinancing an ARM to a fixed-rate mortgage.

It is possible to refinance and that may be an option for some people. If you have enough equity and can afford to refinance before your initial period is over, you can save some money by taking advantage of the low introductory rate without having to worry about increased rates after the initial period ends.

You’ll need to keep a few things in mind. The first is that you’ll need to have at least 20% equity in your home to refinance. Depending on the size of your down payment, it may be a challenge to build sufficient equity to qualify for refinancing.

The second thing to remember is that you’re refinancing to a fixed rate, which means you’ll likely have a rate that’s higher than the introductory rate with your ARM. There are a lot of variables that can impact your interest rate when you refinance. For example, if you’ve paid down debt and your credit has improved since you bought your home, you may be able to qualify for a lower interest rate than you would otherwise.

The final consideration is that you’ll have to pay closing costs when you refinance, which are typically between 3% and 6% of the loan amount. You’ll need to be sure you can afford those costs before you refinance.

Get help choosing the right mortgage for your circumstances

Choosing the right mortgage for your home purchase requires consideration of your financial circumstances, market factors and more. Choosing the right lender is a big part of the equation, and you should keep in mind that credit unions often have more affordable interest rates than banks. If you have any questions about our underwriting process, do not hesitate to contact us. Our knowledgeable team is here to assist you every step of the way!

Are you ready to buy a house? Addition Financial is here to help you with an affordable mortgage that suits your needs. Click here to read about our mortgage options, which include fixed-rate and ARMs, and begin the application process today.