Average Rates by Freddie Mac - 2/21/13
30-year fixed 15-year fixed 5-year ARM 1-year ARM
3.56% 2.77% 2.64% 2.65%
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When shopping for a mortgage loan, you will eventually reach a point where you must choose between a fixed-rate or an adjustable-rate mortgage (ARM). This is an important decision, because it will affect your interest rate and monthly payments over a potentially long period of time.

This article offers a discussion of fixed-rate vs ARM loans. In this lesson, we will discuss the pros and cons of these two options: the fixed-rate both the fixed-rate and adjustable-rate mortgages. Once you understand the key differences, you’ll have an easier time choosing the best loan for your situation.

Let’s start off with a few definitions:

  • A fixed-rate mortgage loan carries the same interest rate over the entire life (term) of the loan. This is true even if you keep the loan for a full 30-year term. The monthly payments also remain the same for the entire term. This appeals to homeowners who prefer to have long-term predictability.
  • An adjustable-rate mortgage (ARM) loan has an interest rate that changes, or adjusts, at predetermined intervals. These days, most arms are actually “hybrid loans.” This means they start off with a fixed interest rate for a certain period of time, after which the rate begins to adjust periodically. An example would be the 5/1 ARM loan. It starts off with a fixed rate for the first five years of the term, after which the rate adjusts every year. That’s what the ’5′ and ’1′ indicate in the title.

So, which one is best for you? How do you choose between the fixed-rate versus the ARM loan? In order to answer this question, you need to consider the pros and cons of each option. So let’s do that.

Fixed vs. Adjustable: The Pros and Cons

The pros and cons of these financing options can be summed up as follows:

  • Fixed-rate loans are more predictable, but they also cost more. Lenders typically charge higher interest rates on these loans, when compared to their adjustable counterparts. But the rate will never change, so the monthly payments will remain static over the term of the loan. You are essentially paying more in interest for the benefit of long-term predictability.
  • ARM loans can be more affordable in the short term, but they are less predictable over the long term. ARM loans typically have lower interest rates during the initial phase, when compared to their fixed counterparts. This is the main reason why homeowners use them in the first place. For instance, the average rate for a 5/1 ARM is typically 0.75% - 0.90% lower than the average rate for a 30-year fixed mortgage.

My advice is to think about your long-term plans. If you expect to be in the house for a long period of time (i.e., more than 10 years), it probably makes more sense to use a 30-year fixed-rate mortgage. On the contrary, if you only plan to be in the house and keep the loan for a few years, you could save money by using an ARM loan with a lower interest rate.

ARM Loans Work Well in Certain Scenarios

Adjustable-rate mortgages have a certain stigma attached to them. They got a bad rap during the housing crisis, and are now commonly cited as one of the contributing factors to that crisis. But this is only half true.

Many of the ARM loans originated during the housing boom had exotic, risky features such as payment options, interest-only payments, negative amortization and the like. Such loans were practically destined to fail. So it should come as no surprise that a high percentage of foreclosures from that period were adjustable-rate mortgages.

Unethical lenders often used ARM loans in conjunction with the high-risk features mentioned above. They did this to attract borrowers who otherwise could not afford to take on a mortgage. They essentially deferred the full cost of the loan a few years down the road, planting the seeds of future financial distress.

In truth, there are scenarios where the adjustable-rate mortgage makes sense. Here’s an example from my own past:

I purchased my first home in 2002. I was in the military at the time, serving a two-year tour in the Baltimore area. We suspected we would only be in the area for three years, at the most. So we used an adjustable-rate mortgage to purchase our house. We got a lower interest rate by using an ARM loan versus a fixed-rate mortgage. This reduced the size of our monthly payments. It was a 5/1 ARM, which meant that it held a fixed rate for the first five years. As anticipated, we ended up selling the house and moving in less than three years. So we were able to reduce our monthly payments and sell the house before the interest rate started to adjust.

When choosing the ARM versus the fixed-rate mortgage, you should consider your long-term plans. You also need to think about how comfortable you are with risk, in the form of an interest rate that changes over time.

  • If your primary goal is to minimize your monthly payments during the first few years, the ARM loan might be your best option.
  • If you’re in it for the long haul, or if the idea of an unpredictable interest rate scares the bejeezus out of you, you should be leaning toward a fixed-rate mortgage loan.

These days, lenders are required to provide more information about ARM loans. When you apply for a mortgage, the lender must give you a Good Faith Estimate (GFE) form that explains how your interest rate may adjust the first time. Here’s a snapshot of that particular section of the GFE form. You can click the image to enlarge it.

The revised version of the Good Faith Estimate offers more transparency than in the past. But it still doesn’t tell you how your interest rate will behave over the long-term, beyond the first adjustment. How could it? Nobody can predict what mortgage rates will do over the next 5, 10 or 15 years.

This article explains the pros and cons of the fixed-rate mortgage versus the ARM loan. Despite its length, this tutorial does not cover every possible lending scenario. Instead, it is meant to give you a clear understanding of the basic differences between these two options. We encourage you to conduct additional research into this subject before making a final decision.

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