Fixed-rate vs adjustable-rate mortgage: how to choose

How a fixed-rate mortgage works

With a fixed-rate mortgage, the interest rate never changes. Your principal and interest payment is the same in year 1 and year 30, no matter what happens to market rates. (Your total payment can still change if property taxes or insurance in your escrow account go up.) If rates fall, you can refinance; if they rise, you keep your rate. That one-sided protection is why fixed rates are usually higher than an ARM's starting rate.

How an adjustable-rate mortgage works

An ARM has two phases:

• Initial fixed period: typically 5, 7 or 10 years at a rate below comparable fixed-rate loans.
• Adjustment period: after that, the rate resets on a schedule — every 6 months on most new ARMs — to an index plus a margin.

The index is a market benchmark; most new ARMs use the Secured Overnight Financing Rate (SOFR), which replaced LIBOR. The margin is a fixed number of percentage points set in your contract, for example 2.75%. If the index is 4.00% at your adjustment date, your new rate would be 6.75%, subject to the caps below.

The name tells you the structure: a 7/6 ARM is fixed for 7 years and then adjusts every 6 months; a 5/6 ARM is fixed for 5 years. Older loans labeled 5/1 or 7/1 adjust once a year after the fixed period.

Rate caps: the three numbers that limit your risk

ARM caps are usually written as three numbers, such as 5/1/5 or 2/1/5:

1. Initial adjustment cap: the most the rate can rise at the first reset (5 or 2 points in these examples).
2. Periodic cap: the most it can rise at each later reset (1 point).
3. Lifetime cap: the most it can ever rise above the starting rate (5 points).

A 6.00% ARM with a 5-point lifetime cap can never go above 11.00%. Many ARMs also have a floor, often equal to the margin, below which the rate can't fall. Find all of these on page 2 of your Loan Estimate, in the "Adjustable Interest Rate (AIR) Table".

Example: a 7/6 ARM vs a 30-year fixed

On a $320,000 loan, suppose you're offered a 30-year fixed at 6.75% or a 7/6 ARM starting at 6.00%:

For seven years the ARM is clearly cheaper: $156.95 less every month and a slightly lower balance at the end. The question is what happens next. At the first reset, the payment is recalculated on the remaining $286,846 over the remaining 23 years:

If rates end up about where they started, the ARM keeps winning. If they rise two points, to 8%, the extra $200 a month would wipe out the ARM's $13,184 head start in about five and a half years. And in the worst case allowed by the caps, the payment jumps by almost $800 a month. Before choosing an ARM, make sure you could survive the capped worst case, not just the expected case.

When an ARM can make sense

• You're confident you'll move within the fixed period — for example, a job relocation planned in five years.
• You'll pay the loan down fast, so the balance exposed to adjustments is small.
• You have room in your budget for the capped maximum payment.

When a fixed rate is the safer choice

• You expect to stay in the home well beyond the initial period.
• Your budget couldn't absorb a payment several hundred dollars higher.
• The gap between the ARM's starting rate and the fixed rate is small — you'd be taking on risk for little savings.

Questions to ask about any ARM

1. How long is the initial fixed period, and how often does the rate adjust after it?
2. Which index is used, and what is the margin?
3. What are the initial, periodic and lifetime caps — and what is the maximum possible payment?
4. Is there a rate floor?
5. How much lower is the starting rate than today's fixed rate on the same loan?

This guide is for general information and is not financial advice. Example figures use the standard amortization formula and are rounded. How we write our guides.