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Home » Home Buying, Mortgages

Fixed Vs. Adjustable Rate Mortgages (ARM’s): Which is Better?

Last updated by on 9 Comments

This post may contain some Mr. Obvious type advice to some – but the fact that certain types of bank products still persist leads me to believe that it won’t be obvious to everyone. And if I can save a handful of readers out there from making an uninformed borrowing choice – it will all be worth it.

As a first-time (or even 2nd or 3rd-time) homebuyer, you are going to have a selection of mortgage products to choose from.

There’s a lot of goofy mortgage offerings out there with funky names like “Jumbo”, “Balloon”, and “Badonkadonk”. General rule: if you can’t tell what something is by the name, odds are very good that it’s not something you should buy.

The two most commonly accepted types of mortgages are fixed rate mortgages and adjustable rate mortgages (ARM’s) – also commonly referred to as variable rate mortgages.

Fixed Rate Mortgage Overview

Fixed rate mortgages are just as the name applies. The borrower and the lender have an agreed upon rate for the mortgage, it’s signed for, and that mortgage rate is fixed. In other words, it does not change, for the life of that loan.

fixed vs adjustable rate mortgageAmong fixed rate mortgages, you’ll most commonly see a 15 or 30 year mortgage.

The longer the term of a fixed rate mortgage, the higher the mortgage rate. For example, right now, 30-year fixed rate mortgage interest rates average 4.38%, while 15-year fixed rate mortgages average 3.42% APR – almost a full percentage point lower.

Why is this?

It’s all about risk.

When a lender lends you money, they are assuming risk that comes with the possibility of interest rates rising and the return on their investment in you (your loan) being worth less. At any point, the fed funds rate could change, pushing the going prime rate higher and mortgage rates typically follow suit. The longer the term of the mortgage, the higher the risk assumed by the lender. As a borrower, you have your rate locked in. There is zero risk that interest rates will rise on you – the contract you have signed with your bank guarantees they will stay the same.

As the borrower, you can also refinance your mortgage if you have locked yourself in to a rate that is higher than today’s rate. The lender, on the other hand, cannot do the same to you if they’ve determined that the rate you locked in with them is no longer favorable.

For this reason – fixed rate mortgages, by design, are very consumer friendly. You determine how much you should put towards your down payment and know what you’re going to get up front on the interest rate. No surprises or changes.

Adjustable Rate Mortgage Overview:

Then there’s adjustable rate mortgages (ARM’s).

ARM’s are the lending industry’s attempt to swing the pendulum of risk back in their favor, by design.

When you sign up for an ARM, you know what your introductory rate is and generally how long it lasts. But from there, it is connected to the prime rate and can change on you often. There is little risk to the bank, because if interest rates increase, they simply raise the rate on your ARM.

Why would any borrower sign up for something like this?

Well, that’s a good question. And one you should probably ask the sales guy urging you to choose it (if you haven’t already walked out of the building).

Because ARM’s are so blatantly higher risk to borrowers than fixed rate mortgages, lenders have to have a hook to get borrowers interested. That hook often comes in the form of a sexy teaser rate. A teaser rate is the initial interest rate you will pay for the loan. For example, right now, I was able to find a number of ARM’s with a teaser rate in the 2.7% – 3.0% APR range (lower than the fixed rate mortgage rate averages I highlighted earlier). Often times these teaser rates are only good for the first month or so.

If you’re a borrower who doesn’t read all of the fine print or is susceptible to taking the bait – you might jump at the low interest rate, thinking you’re getting a bargain. But a year from now you might be paying an interest rate that is higher than the fixed rate you could have locked in. And 10 years from now, you might be paying a significantly higher rate. For this reason – much like with payday loans (which should be banned) – there is a predatory nature in the offering (albeit much less predatory and harmful).

Some ARM’s have fancy terms that will highlight various caps, so you might feel like there is some protection involved – but if you need a lawyer and a week of time to understand all of the terms, you should probably run away from the deal.

There are also “hybrid ARM’s” that have a fixed rate for a longer specified period of time, before turning to a variable rate. For example a 5/1 ARM would have a fixed rate period of five years before being adjust on an annual basis. A 3/1 ARM, 3 years, then every year. If you knew you were going to be at a specific location for just a few years, one of these mortgages might make sense. BUT, and this is key, the introductory period rate would have to be much more attractive than the current fixed rate offerings. Right now, that’s not the case at all. In fact, the average 5/1 ARM today has a 5-year rate that is higher than 15-year mortgages. Why not simply go with the lower rate, especially since it is locked in for more than 5 years?

Are there Any Scenarios is which an ARM would be Attractive?

One possible scenario where an ARM mortgage might make some sense is in a very high interest rate environment, where the odds of the interest rate declining in the future are likely – and a refi would not be necessary if the ARM self-adjusted (potentially saving the borrower thousands in refi costs). Many ARM’s will be self-protected against this, however, by setting a “floor” clause that prevents the ARM from adjusting lower than the start rate offered or to within a specified percentage point lower than the start rate. You can also bet that in this type of interest rate environment that many ARM products would cease to be offered by lenders.

The reality is, we’re not in that situation today. Mortgage interest rates are near historical lows, and the odds of them going lower are slim to none. Today’s interest rate environment puts all of the risky squarely with the lender. In other words, there’s never been a better time for borrowers to get a fixed rate mortgage that will lock them in to a low long-term interest rate. So when you get sold the idea of an ARM, tell the guy, “Sorry, I know better”. Then, “See ya later, Pal”.

Fixed Rate vs. ARM Discussion:

  • Do you or have you ever had an ARM? Why? And what have you learned?
  • Have you been aggressively pitched an ARM?
  • What is your current fixed or adjustable mortgage rate?
  • Do you foresee any situations in which an ARM might be more attractive to you than a fixed rate mortgage?

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9 Comments »
  • Great breakdown and comparison! I think the bottom line is that when mortgage rates are so low, there’s really no reason to go for an ARM. We have a fixed rate on our mortgage, and it’s at 3.6% – that’s the same reason we’re not in a hurry to pay it off early. We can get a better return on investments elsewhere, and allow the principal we pay to be a tax write-off.

  • Ryan says:

    I have two mortgages, both at fixed rate – 30 year. I avoided any ‘sell’ by telling them right away that is what I was looking for when I called around. They were about a year apart in the summer months: 3.75% for my duplex bought in 2012 and 3.625% on my residence purchased in 2013. At the moment, I don’t plan to pay either one early. I probably will never need to refinance either.

    An interesting tidbit – I know someone who bought right around the time I did, but was borrowing 30-40k less (~70k loan) and his rate for a 15 year was actually higher than my 30 year. Obviously, the bank stands to make less money on the 15 year which is why the rate was different. Something for potential buyers to think and know about…

  • Carla says:

    1. ARM’s are generally tied to something like LIBOR or the 1 Year T Bill, not prime. These fluctuate much more frequently and are generally a better deal for the lender.

    2. No, lenders did not stop offering ARM’s while rates were falling… and I have no idea why they would. The chances of rates going back up in the 30 years of a loan’s life are pretty good.

  • Brian says:

    Two times that I’ve come across that seem like a pretty solid justification for using an ARM (assuming you understand the terms of the loan).

    1) I had a friend take out a 5/1 ARM because they were living well below their means and planned to put an extra few hundred dollars/month towards their mortgage in order to pay it off in about 3 years. This was about 3 years ago, so the rates were a bit different, but I believe they got something like a 3.5% rate instead of 5%. This saved them a decent amount of month each month that they could put straight towards erasing their principal more quickly. Due to fairly stable income/jobs, there was fairly little risk in them not paying it off within the five years.

    2) Similar timeline, but different justification… We bought our house on a 95% 30-yr fixed loan in 2007 at around 6.5%. By 2011, we had saved enough that we were comfortable paying down the principal to shed PMI and rates had dropped enough that we could get around a 4% 30-yr fixed or a 2.75% 5/1 ARM. Because we were only planning on being in the area for around 3-4 more years due to jobs the 5/1 ARM worked well and saved us quite a bit of money over what the 30-yr fixed would have.

    Both of these situations have a couple of similarites… High degree of certainty of not needing the loan beyond the fixed period and also that taking out a 15-yr fixed COULD have lead to a similar interest rate but does lock in a higher amount of monthly income into house payments that a 5/1 allows (because it is a 30-yr term).

    • Money man says:

      You made a great point on timeframe. If your timeframe is more or less the “teaser period” then why not get the lower rate with the ARM. I’d disagree with the decision to get the ARM just so principal could be paid down faster when the money was available since rates are so low already bad the opportunity cost of not putting it in even conservative investments would be greater than the interest saved. Just my two cents.

      • Brian says:

        I agree, and even thought about putting a disclaimer in that I’m not saying the underlying financial decision was the appropriate one. However, I believe it does still illustrate a scenario that ARM is better than fixed. For what it’s worth, I have a 30 yr fixed at ~3.6% from this Spring (after moving out of the aforementioned city to a new one for job puroposes).

  • Ron Ablang says:

    My parents bought their 1st home in 1985 and insisted that I only go w/ a fixed rate loan. I guess they saw a lot of horror stories w/ other people going w/ ARMs during that time.

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