Fixed vs Adjustable-Rate Mortgage: Which Is Right for You?

A fixed-rate mortgage keeps the same interest rate and principal-and-interest payment for the whole loan, while an adjustable-rate mortgage (ARM) starts with a set rate for a few years and then moves with a market index. An ARM usually makes sense only if you expect to sell or refinance before the fixed period ends, or you could comfortably afford the maximum payment its caps allow.

Here is how an ARM resets, what the numbers in its name mean, a worst-case payment table, and a decision tree to help you choose.

How a fixed-rate mortgage works

The rate is set at closing and never changes. Your principal-and-interest payment stays the same for 15, 20 or 30 years. Taxes, insurance and maintenance can still rise, but the loan itself is predictable. The trade-off is that a fixed rate can be higher than an ARM’s starting rate, and if rates fall you need to refinance (and pay closing costs) to benefit.

How an ARM works

The name: 5/1, 5/6, 7/6

The Consumer Financial Protection Bureau’s ARM handbook explains that the first number is how many years the starting rate lasts and the second is how often it changes after that. A 5/1 ARM is fixed for five years and then adjusts every year. A 5/6m ARM is fixed for five years and then adjusts every six months. The time between changes is the adjustment period.

The rate: index plus margin

After the fixed period, your rate becomes an index (a published measure of market rates) plus a margin (a fixed number of percentage points the lender adds). The index moves; the margin does not. For loans sold to Fannie Mae, the index is the 30-day average of SOFR published by the Federal Reserve Bank of New York, taken 45 days before the change date. Your Loan Estimate shows the index and margin offered to you, and you can shop lenders for the lowest combination.

Watch for a starting rate below the “fully indexed” rate. The CFPB’s example: an index of 2% plus a 2.5% margin is 4.5%. If the loan starts at a 3% teaser rate, your rate rises to 4.5% at the first change even if the index never moves.

The caps

Most ARMs limit how far the rate can move. Caps can differ for the first change and later changes:

• Initial adjustment cap: the most the rate can rise at the first change.
• Subsequent (periodic) cap: the most it can rise at each later change.
• Lifetime cap: the most it can ever rise above the starting rate.

Caps are sometimes quoted as three numbers in that order. For example, a “5/1/5” structure would mean up to 5 points at the first change, 1 point at each later change and 5 points over the life of the loan; “2/1/5” would mean 2, 1 and 5. These are examples, not standard terms for every ARM. The CFPB handbook’s sample Loan Estimate shows a loan starting at 3% with 2-point limits on the first and later changes and a maximum rate of 8%. Your loan’s Adjustable Interest Rate (AIR) table on page 2 of the Loan Estimate lists the exact caps, minimum and maximum rate.

What the caps can do to your payment

In this example the ARM saves about $245 a month, or roughly $20,600 over seven years, compared with a 6.75% fixed loan, and its balance is about $5,700 lower after seven years. But in the worst case the payment can jump by nearly $1,500 a month. A 2/1/5 cap spreads the increase out; a 5/1/5 cap allows the whole jump at once.

Fixed vs ARM side by side

The CFPB notes ARMs often start lower than fixed rates, but falling market rates do not always lower your payment: some ARMs also cap decreases, and the rate is generally never lower than the margin.

ARMs and NYC co-ops

If you are buying a co-op, check the building’s rules before choosing an ARM. Co-op boards set their own financial tests, and some set their own rules for how the mortgage payment is counted. Hauseit reports one Lower Manhattan co-op that does not permit adjustable-rate or interest-only loans for purchases. Ask the managing agent before you lock a loan. See co-op share loans vs mortgages.

Lenders also protect against payment shock: for Fannie Mae ARMs with an initial fixed period of five years or less, lenders must qualify you under Fannie Mae’s special qualifying-payment rules, which exist to limit payment shock.

Which one fits you?

Compare your own offers

When you compare Loan Estimates, line up the starting rate, index, margin, caps, maximum rate and the points each lender charges. Points can make a lower rate look better than it is; see mortgage points and buydowns. To weigh term length instead, use the 15 vs 30-year mortgage calculator.

This guide is general information. Your note and Loan Estimate set the actual terms of your loan.