It’s important to know the differences between Fixed vs. ARMs so you can make an informed decision on your loan.
There are two major rate types, and they’re incredibly different.
- Fixed Rate Loans – The interest rate for the loan is set for the life of the loan and does not change.
- Adjustable Rate Loans or ARMs – The interest rate is set for a period of time, and then adjusts regularly over the life of the loan. Also often called variable rate loans.
This difference between Fixed vs. ARMs or variable rate loans is huge. With a variable interest rate loan, as your interest rate adjusts, your monthly payment adjusts with it. This was the problem for many during the 2008 housing crisis. The interest rate on their loans adjusted, and suddenly they couldn’t afford the monthly payments, which lead to foreclosures.
Variable rate loans force you to try to see into the future. You are taking out a home loan right now that will affect your life in 5, 7, or 10 years from now. It’s hard to know what the future holds.
There are some scenarios where ARMs can work in your favor. For instance, if interest rates go down in that period, you get a raise at work, you intend to leave the home before the adjustment date, or your house appreciates significantly in that time frame.
However, what if you lose your job? Or what if interest rates rise significantly? Or what if you decide not to move within that time frame? In these cases, an adjustable rate mortgage works against you.
Adjustable rate mortgages aren’t all bad, though. They can actually be pretty useful if you understand how they work and use them responsibly.
How ARMs Work
Adjustable rate loans usually have a few basic components. At the start, they have an artificially low interest rate. This “intro rate” can last as little as 1 month or as long as 5 years. After the intro period, the interest rate will adjust, and will continue to adjust every month, quarter, year, 3 years or 5 years — however long your adjustment period is.
The adjustment is tied to a market index: the interest rate on your loan would go up or down as the value of some other thing fluctuates, usually the LIBOR index, the federal funds rate, or the Treasury note rate. If that index goes up, your rate goes up and your monthly payment goes up. If it goes down, your rate goes down and your payment actually goes down with it. (That part is kind of cool.)
- Because of the low interest rate during the intro period, ARMs can be great short-term loans.
If you plan to be in the property for a short period of time (e.g., you’re going to move before the interest rate adjusts), then an ARM may work well for you. It will usually offer a significantly lower monthly payment than a 30-year fixed rate mortgage, and a lower lifetime cost over those 5 years.
In certain scenarios, an ARM can work wonders for you, leaving you with lower payments and more equity. In exchange for those benefits, you take on the risk that the ARM loan will adjust to a significantly higher interest rate at the end of the intro period.
We highly recommend doing your own research before deciding on an adjustable rate mortgage. To learn more about whether an ARM or variable rate loan may be right for you, here are some other resources to start with:
- The Pros and Cons of Adjustable Rate Mortgages by NerdWallet
- A cautionary tale from 2006 – Nightmare Mortgages by Bloomberg
- 3 Reasons an Adjustable-Rate Mortgage is a Great Idea by The Motley Fool