Find Your Match: Fixed- vs. Adjustable-Rate Mortgages (ARM)

Like homes themselves, mortgages come in many sizes and types. One of the most important decisions you face as you consider your choices is whether to take out a fixed- or an adjustable-rate mortgage. The one that's right for you depends on many factors, such as your tolerance for risk, how long you expect to stay in your home, and current rates.

Types of mortgage loans

Fixed-rate mortgages

Fixed-rate mortgages are very popular with homebuyers because loan payments are predictable. As the name implies, the interest rate on a conventional fixed-rate mortgage remains the same throughout the term (length) of the loan. Your monthly payment (consisting of principal and interest) remains the same as well. The entire mortgage is repaid in equal monthly installments over the term of the loan (e.g., 15, 20, 30 years).

Locking in a fixed interest rate on your mortgage has its pros and cons. If interest rates rise, yours won't; as a result, your monthly mortgage payment will always remain the same. This can be reassuring to homeowners on tight budgets or with fixed incomes. For this reason, fixed-rate mortgages often appeal to individuals with a low tolerance for the risk associated with fluctuating monthly payments.

But if interest rates go down, yours won't, and your (comparatively high) mortgage payment will remain the same. While you might be able to refinance your home, paying off the higher-rate mortgage with one that carries a lower interest rate, this isn't always possible. In addition, the interest rate might need to drop significantly to offset the expenses associated with refinancing, and you'd need to remain in your home long enough to allow the monthly savings associated with the lower rate to recoup those expenses.

Adjustable-rate mortgages (ARMs)

ARMs are mortgage loans that offer a fixed interest rate for a certain period (3, 5, 7, or 10 years), and then convert to a 1-year ARM. Your interest rate is adjusted periodically, rising or falling to keep pace with changes in market interest rate fluctuations. Since the term of your mortgage remains constant, the amount necessary to pay off your loan by the end of the term changes as your loan's interest rate changes. Thus, your monthly payment amount is recalculated with each rate adjustment.

Depending on what's specified in the mortgage contract, an ARM can be adjusted semi-annually, quarterly, or even monthly, but most are adjusted annually. The adjustments are made on the basis of a formula specified in the mortgage contract. To adjust the rate, the lender uses an index that reflects general interest rate trends, such as the one-year Treasury securities index, and adds to it a defined margin to determine your loan interest rate. Thus, if the index is 3.13% and the markup is 2.25%, the ARM interest rate would be 5.38%.

What's to keep the interest rate from going through the roof – or, for that matter, from plunging through the floor? Most ARMs specify interest rate caps. The periodic adjustment cap may limit the amount of rate change, up or down, allowed at any single adjustment period. A lifetime cap may indicate that the interest rate may not go any higher – or lower – than a specified percentage over – or under – the initial interest rate.

The initial fixed interest rate for an ARM is often considerably lower than the rate on either a 15- or 30-year fixed-rate mortgage. The longer the initial fixed-rate term, however, the higher the interest rate for that term will be. Generally, even the lowest of these fixed rates is higher than the initial (teaser) rate of a conventional 1-year ARM.

The best mortgage loan product will depend on your unique circumstances coupled with what interest rates are doing at the time of your application. A rising rate environment, which is what we’re currently experiencing, makes borrowing more expensive. As a result, demand for ARMs goes up because the interest rates offered on these products are typically lower than those for fixed-rate mortgages. This is to offset the uncertainty of fluctuating market conditions. In April, the demand for ARMs was double that of previous months as rates continue to rise.¹

The impact of today’s rates

ARMs are ideal for individuals who plan to stay in their homes for a short period of time (3 to 10 years), since they can take advantage of the low initial fixed interest rate without worrying about how the loan will change when it converts to an ARM. An ARM loan may also be good if you expect to refinance in the short term or if you think rates will decrease. 

Similarly, demand for both fixed-rate mortgages and refinances increase in low-rate environments. Homebuyers want to lock in a guaranteed low rate for the entire life of their loan. Plus, homeowners who are currently paying off a high-interest rate mortgage may want to take advantage of conditions and score a lower rate – and a more affordable monthly payment – through refinancing. 

Tip: Want to learn more about rising interest rates and how they affect homebuying? Watch Home Loans 101, featuring General Electric Credit Union’s (GECU) Senior Vice President Mortgage Operations, Andy Dunn. 

Still unsure which option is best for you? Talk it through with a dedicated GECU team member. Schedule an appointment online and skip the lines at your next in-branch visit. We’ll walk you through the mortgage loans available to you and the factors that may influence your decision. You can also use our online mortgage calculators to get an idea of your mortgage payment on a potential home purchase, gauge affordability, and much more!