Adjustable-Rate Mortgage vs. Fixed Rate Mortgage

With rising interest rates like we’ve had since January it’s not all bad news for homebuyers as some might think. The surge in interest rates has resulted in an uptick in housing inventory, potentially less competition for homebuyers, and an increased interest in mortgage solutions that have been neglected recently – like the adjustable-rate mortgage (ARM). Many will remember the ARM, and some may have used this type of mortgage loan. It was introduced around 1981 when interest rates peaked at around 17% and then dropped off over the next 15 years to a little over 9% in 1995-96.

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When it comes to securing a loan it’s important to understand all available options. This blog provides a shallow dive into the adjustable-rate mortgage and how it may help a homebuyer save money on a loan, especially if they plan to live in the home for only a few years.

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How Are ARMs And Fixed-Rate Mortgages Different?

Very simply, the major differences between ARMs and fixed-rate mortgages are their interest rate structure:

• The fixed-rate mortgage offers the homebuyer constant interest rate over the term of the loan, providing the predictability and security many homebuyers prefer.

• The ARM normally offers a lower initial interest rate, making it easier to get into the home, but has the possibility of higher rates stepping up during each scheduled rate adjustment period over the term of the loan. A step up may, or may not, happen – it is dependent upon the movement of the financial rate index on which the loan is based.

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How is the ‘Adjustable’ Part of the ARM Determined? 

Most ARMs feature a combination of an initial rate that is fixed for a defined period and is then followed by rate adjustments, up or down, on a scheduled basis. These adjustments are calculated using an independent financial rate index such as the Secured Overnight Financing Rate (SOFR) plus a lender-defined margin that is established at loan initiation. Most ARMs include rate-change caps per adjustment period as well as for the full term of the loan. Other independent financial indices for ARM mortgages are: the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime Rate, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds Index (COFI).

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Are There Different Types of ARMs? 

There are several popular types of ARMs with the most common being 3/6, 5/6, 7/6, and 10/6. The first number represents the period during which your interest rate will be fixed, and the second number represents how often your interest rate can change after the fixed period expires.

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3/6 ARM - Features a fixed interest rate for the first three years (“3”) followed by adjustments on a semiannual basis (“6”) over the remaining term. 

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5/6 ARM - A five-year fixed-rate period followed by semiannual adjustments over the remaining term.

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7/6 ARM - A seven-year fixed-rate period followed by semiannual adjustments over the remaining term. 

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10/6 ARM - A 10-year fixed-rate period with semiannual adjustments thereafter. 

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What Happens When the Fixed Period Ends?

Following your fixed-rate period, your interest rate can increase or decrease each year for the remaining years of the mortgage depending on the movement of the financial rate index it is tied to. Fortunately, caps are set to protect against potential ‘runaway’ increases should a particularly sharp inflationary period, such as we now have, occur.

• An initial adjustment cap limits how much your rate can increase the first time it adjusts. For example – the initial cap on a standard 5/6 ARM is 2% - meaning your interest rate cannot increase by more than 2% at your first adjustment period.

• A periodic cap limits how much your rate can adjust at specified adjustment dates.

• A lifetime cap limits how much your rate can increase over the life of your loan.

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Should I Consider An ARM? 

Many first-time homebuyers are attracted to ARMs because of the benefits they provide during the initial fixed-rate period. These include:

• Lower loan payments

• Ability to apply initial savings to other needs upgrades or new appliances

• Lower overall loan cost if the consumer plans to sell/move to a larger home before a scheduled rate adjustment (Note: Some ARMs include an early payoff penalty)

• Possibility of additional savings if rates are adjusted downward

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Which Lenders Should Be Considered When Shopping For An Adjustable-Rate Mortgage? 

Just as important as carefully selecting the home, it is important for homebuyers to do their research and consult with an experienced professional. Homebuyers should seek out lenders who can explain all the available options as mortgage solutions aren’t one-size-fits-all. Not all lenders offer the same products so one would naturally gravitate toward those that had the broadest selection of ARM products, knowledgeable loan officers to help the homebuyer get pre-approved, thoroughly explain the different ARM options, or introduce them to specialty purchase programs in which the lender is able to tailor a loan to fit a buyer’s lifestyle and personal situation. 

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Consulting with a knowledgeable professional is the best way to find the right option for your unique situation. Homebuyers who plan to stay in their new homes over the long haul and/or are risk averse, low risk tolerance, will likely be best served by a fixed-rate mortgage. However, an ARM is an excellent choice for many first-time homebuyers seeking a lower initial interest rate combined with added flexibility to align with their unique financial needs. Remember that down the road your financial situation may change and perhaps desire more stability, you may be able to refinance into a fixed-rate mortgage.

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Check with the Geni Manning Team for more information and to receive suggestions regarding a few experienced professional lenders on our team that can provide you the answers you desire – no obligation – just fill out the information below.