Fixed-Rate vs. Adjustable-Rate Mortgages

When going out to get a mortgage, the one thing people have as their top priority is to find the lowest rate of interest.

This is quite different from shopping for anything else where lowest price isn’t always the top priority. Buyers often also look for the quality of the product, its brand, reviews, etc.

The reason people think that way about mortgages is because a mortgage is a product where someone is lending you money. They’ll all lend you the same currency and the same amount. They think that as long as it’s the lowest rate, it’s the best choice.

That is a reasonable way to think about it. Except, the lowest rate of interest isn’t the metric to focus on. The lowest amount of interest is what should be. And therein comes the choice of mortgage product.

Choosing the right product can often have a bigger impact than getting a modestly lower rate. In this article, we’ll compare the two most popular types of mortgages (shown as follows), to help you make a decision on which one is better for you: 

• Fixed Rate Mortgage (FRM); and
• Adjustable Rate Mortgage (ARM) 

A short description of FRM and ARM first

As the names suggest, the rate on an FRM is fixed at the time of origination and doesn’t ever change. An ARM on the other hand is adjustable, meaning the interest rate you pay can vary or adjust every year.

The most popular type of ARM is a hybrid ARM. Ever heard of a 5/1 ARM or a 7/1 ARM? Those are Hybrid ARMs. Instead of adjusting every year, the rate for these remains fixed for a few years (typically 3, 5, 7 or 10 years) and after that, the rate can adjust every year.

The obvious next question: “And which one is better?”

We’ll turn the question back to you. What would your concern be with each of those?

A Fixed Rate Mortgage (FRM) is simple. It does not have much downside because it is as straightforward as it gets. Because you can refinance at any time and you can prepay any part of the loan without any penalty, the fact that the rate does not change ever makes the FRM an obvious choice.

This is very much reflected in the fact that fixed-rate mortgage origination is many times more than that of an ARM, as can be seen in this research paper published by the New York Fed.

An ARM (and that includes a hybrid ARM), on the other hand, is complicated. It not only has the risk of the interest rate increasing over time, it is fairly involved in terms of its intricacies and nuances. 

Does that mean one should not get an ARM?

No. In fact, ARM products exist for a reason and 10% of people do get it. And to understand why, let’s dive deeper into understanding how an ARM works.

So how exactly does an ARM work?

As the name suggests, the rate on an ARM is “Adjustable”. Unlike a fixed-rate mortgage where your interest rate is fixed throughout the term of the mortgage, in an ARM, the interest rate you pay can vary or “adjust” every year. The interest rate that one typically pays is the sum total of two rates: 

1. The prevailing market rate called the “index” rate; and 
2. A borrower-specific rate called “margin” rate.

Index Rate

Index rate is a rate that is widely published, such as the rate on a 1-Year US Treasury Bond, which is the interest rate that the US Government pays to borrow money for one year. Or it could be another rate such as the LIBOR rate (rates that the big banks charge to lend to each other). 

Margin Rate

Since a normal mortgage borrower is more likely to not pay back than the US government or a big bank, the lender asks the borrower for more interest (“margin”) to compensate it for that additional risk. So in essence, the borrower’s rate is effectively the index plus the margin. 

The better the credit history and income of a borrower is, the higher the likelihood of them paying them back is. In such a case, the lender is willing to charge a lower margin since the risk is lower.

Adjustment dates

The rate on an ARM “adjusts” periodically, based on a period specified at the time of origination of the loan. For most ARMs, a typical adjustment period is once a year.

Does that mean one should not get an ARM?

No. In fact, ARM products exist for a reason and 10% of people do get it. And to understand why, let’s dive deeper into understanding how an ARM works.

So how exactly does an ARM work?

As the name suggests, the rate on an ARM is “Adjustable”. Unlike a fixed-rate mortgage where your interest rate is fixed throughout the term of the mortgage, in an ARM, the interest rate you pay can vary or “adjust” every year. The interest rate that one typically pays is the sum total of two rates: 

1. The prevailing market rate called the “index” rate; and 
2. A borrower-specific rate called “margin” rate.

Index Rate

Index rate is a rate that is widely published, such as the rate on a 1-Year US Treasury Bond, which is the interest rate that the US Government pays to borrow money for one year. Or it could be another rate such as the LIBOR rate (rates that the big banks charge to lend to each other). 

Margin Rate

Since a normal mortgage borrower is more likely to not pay back than the US government or a big bank, the lender asks the borrower for more interest (“margin”) to compensate it for that additional risk. So in essence, the borrower’s rate is effectively the index plus the margin. 

The better the credit history and income of a borrower is, the higher the likelihood of them paying them back is. In such a case, the lender is willing to charge a lower margin since the risk is lower.

Adjustment dates

The rate on an ARM “adjusts” periodically, based on a period specified at the time of origination of the loan. For most ARMs, a typical adjustment period is once a year.

Can my rate go up infinitely?

The short answer is no. There are predefined limits called “caps” on how high the rate can go in a year and over the life of the loan. These are meant to protect the borrower from excessive risk.

(1) Lifetime Cap – A lifetime cap is the maximum annual interest rate a borrower will ever pay through the term of the loan. People like that because that sort of locks what their highest payment ever can be.

(2) Periodic Cap – This sets the maximum rise one can see between two successive rate adjustments.

Lastly, a quick work about the hybrid ARM

The “hybrid” feature in an ARM is what perhaps draws people the most towards ARMs. In fact, of all the mortgages that have an “adjustable” rate, this one’s by far the most popular. 

The reason being that it has good features of both a fixed-rate mortgage and an ARM. 

The rate remains fixed for a few years and then typically adjusts once a year. The most popular types are 5/1, 7/1 and 10/1. 

In a 5/1 Hybrid ARM with a term of 30 years, the rate remains fixed (at a pre-specified rate) for “5” years and then changes once a year (“1”) for the next 25 years, just like a simple ARM. 

The fixed-rate during the first 5 year period is typically lower than the traditional 30-year mortgage, thereby reducing the borrower payment during the initial period. The risk of course is that that rate may go up once the 5-year period is over.

What’s the biggest issue with an ARM?

The biggest worry most have with an ARM is the index rate going up with time. 

What that means is if that happens, one might have to make a higher monthly payment in the future than in the beginning. 

That is a risk and most people don’t like that kind of uncertainty. That’s the reason why a lot of people choose fixed rate mortgages. 

But does that mean it’s all risk with ARMs? The answer is “No”. In certain circumstances that are explained later in this article, an ARM can be a pretty good choice.

When is ARM a good choice?

An ARM might be a reasonable choice for you when mortgage rates are high and affording a payment is difficult. 

In such a situation, getting an ARM because of its typically lower rate (than a fixed-rate mortgage), at least in the initial years, might not be a bad idea. It lowers one’s monthly payment for a few years. 

The biggest problem is the risk of rates going up even more after the initial period is over. That might be a big risk but still worth taking if one or more of the following is true:

• Plan to sell the home before expiration of the initial period – If you plan to sell the home before the initial period is over, a Hybrid ARM is virtually a fixed-rate mortgage with a lower rate than the conventional 30-year fixed.
• High-Income individuals – For those that have a substantially high income and think they can pay off the loan before the initial period expires, ARM might be a better choice. Since they expect to pay off the loan sooner, they’ll never have to deal with the risk of increased rates later and pay a lower rate.
• Reduction in other debt – If people getting a mortgage have other debt because of which affording a higher mortgage payment is difficult in the beginning, then they can go with an ARM to keep payments lower and then refinance when the other debt is paid off.
• Future Income Increase – If one expects his or her income to rise substantially in the future, Hybrid ARM is not a bad idea. So even if rates go up, there is some level of assurance of being able to make the higher future payments.
• Strong expectation of future decrease in rates – If one has strong reasons to believe that rates in the future will go down, an ARM might be a reasonable choice.

The Consumer Handbook of ARMs (CHARM) Booklet

Consumer Financial Protection Bureau (CFPB) has published a Consumer HandBook on ARMs (also called the CHARM booklet) to make borrowers aware of all these aspects and the pitfalls of getting an ARM in much greater detail.

Because ARMs are more complex than FRMs, the CFPB has mandated that anyone who has applied for an ARM should be provided with the CHARM booklet as a part of initial disclosures by the lender. This is to make sure consumers have a better understanding of the ARM product that they are getting.

Let’s summarize everything

Now that we explained how an ARM works and also told you the pros and cons of it, there a few takeaways regarding deciding between an FRM and an ARM:

• A typical ARM will have a maturity of 30 years.
• An ARM will have a fixed rate for a few years and then the rate can change every year after that.
• How high this rate can go has certain limits (see section above can my rate go up infinitely?)
• The rate during the fixed period often tends to be lower than the rate for a Fixed Rate Mortgage (FRM)
• This might be enticing because you can have a lower monthly payment for the first few years
• Choosing to go with ARM is fine, but make sure you read the section above title When is ARM a good choice?
• If you don’t think any of those situations apply to you, it’s likely ARM is not a good choice in such a case.

But if you still can’t decide for yourself whether to go with a FRM or an ARM, we’d be happy to help and guide you in your decision. At Stem Lending, that’s what we love to do. You can start an application at: stemlending.com/apply or write to us at [email protected]