Adjustable-Rate Mortgage (ARM) vs. Fixed-Rate Mortgage

Definition

A Fixed-Rate Mortgage has an interest rate that remains constant throughout the entire loan term, while an Adjustable-Rate Mortgage (ARM) starts with a fixed rate for an initial period but then adjusts periodically based on market interest rates.

Explanation

Choosing between an ARM and a Fixed-Rate Mortgage depends on how long a borrower plans to stay in the home, their risk tolerance, and current market conditions.

Fixed-Rate Mortgage (FRM)

✅ Interest rate stays the same for the life of the loan.
✅ Monthly payments remain predictable.
✅ Ideal for long-term homeowners who want stability.
❌ Higher initial interest rate compared to ARMs.
❌ Less flexibility if interest rates drop in the future.

Adjustable-Rate Mortgage (ARM)

✅ Lower initial interest rate (often lower than fixed-rate loans).
✅ Ideal for short-term homeowners who plan to sell before rates adjust.
✅ Can benefit borrowers if interest rates drop after the fixed period.
❌ Uncertainty – Payments increase if rates rise after the fixed period.
❌ Harder to budget long-term due to fluctuating payments.

How ARMs Work

• The loan starts with a fixed rate for an initial period (e.g., 5, 7, or 10 years).
• After that, the rate adjusts periodically (usually every year) based on an index like the SOFR (Secured Overnight Financing Rate).
• ARMs have caps that limit how much the interest rate can increase per adjustment and over the life of the loan.

Example of an ARM vs. Fixed-Rate Mortgage

A borrower takes out a $400,000 mortgage and compares:

• The ARM starts with a lower initial payment, saving the borrower money in the early years.
• However, if interest rates rise, the borrower could end up paying more than if they had chosen a fixed-rate loan.

When to Choose an ARM vs. a Fixed-Rate Mortgage