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Choosing a mortgage is complicated. One of the first choices you’ll make is also one of the most consequential—fixed rate or adjustable rate?
Your decision will impact not only your monthly payment, but how long it takes you to pay off your mortgage and how much interest you’ll pay along the way.
An adjustable rate mortgage, or ARM, can be a better choice in very specific circumstances, but with interest rates at record low levels this year, a fixed-rate mortgage is the clear winner for most borrowers right now.
The percentage of ARM applications has dropped by 50% since late March 2020, and has accounted for 3% of all residential mortgage applications, according to data from the Mortgage Bankers Association.
Differences Between Fixed-Rate and Adjustable-Rate Mortgages
The most important difference between fixed-rate mortgages and ARMs is straightforward. A fixed-rate mortgage has an interest rate that doesn’t change. An adjustable rate mortgage’s interest rate changes at predetermined times, up to limits outlined in the loan’s fine print.
An ARM’s rate will reset on different timelines depending on the loan. The interest rate adjustment schedule is shown as a fraction. The first number in the fraction is when the rate initially resets, and the second number is how frequently it changes after the first adjustment. So a 5/1 ARM has a fixed rate for five years and then the rate adjusts annually afterward. Typically, an ARM is a 30-year mortgage.
A fixed-rate mortgage is more straightforward than its variable rate counterpart. The main difference you’ll find with fixed-rate loans is in the amortization schedule, or loan terms. Just like with ARMs, there are 30-year fixed-rate mortgages. But you can also choose shorter terms, like 10 years or 15 years.
With a fixed-rate mortgage you can opt for shorter terms. You’ll have a bigger monthly payment, you’ll pay off your mortgage much more quickly.
Why ARMs Don’t Make Sense Right Now
Choosing between an ARM and a fixed-rate mortgage is all about risk versus reward. With a fixed-rate mortgage the borrower locks in a rate for the life of the mortgage. With an adjustable rate, the borrower takes on the risk of their rate rising in the future. In exchange for the increased risk, the borrower typically gets a lower starting interest rate.
Right now, the difference in starting rates for adjustable mortgages is minimal to nonexistent relative to a fixed-rate loan, explains Greg McBride, chief financial analyst at Bankrate.com. “If you’re not getting any benefit, but still shouldering the same amount of risk, why bother?”
The current economic outlook only adds to the ARM’s dwindling appeal. One situation where ARMs traditionally have made sense is when you plan on selling the property before the rate resets. This strategy relies on housing prices rising or at least staying stable.
While home prices have increased in many areas, driven by record low mortgage rates and low housing inventory, no one can guarantee this will continue in the long term. After all, in January 2020, how many experts were predicting a multi-trillion dollar decline in the global economy? And with unemployment still in double digits and COVID-19 still rising late into the summer in many parts of America, it’s important to plan for future uncertainty.
After declining steadily since the ’80s, mortgage rates don’t have much more room to fall. So, if you’re in a position to afford a home or to refinance, locking in a fixed rate is the way to go.
Also, with a fixed-rate mortgage you have the flexibility to choose a shorter repayment term, like a 15-year loan. Compared to a 30-year mortgage, a 15-year home loan will have a lower interest rate, but higher monthly payments. You may potentially pay more per month, but borrowers are willing to do this in order to pay off the debt faster and save thousands of dollars in interest payments over the life of the loan, says Nadia Alcide, a mortgage professional with Mortgage Biz of Florida. And the option to take a shorter term mortgage isn’t typically available with an ARM.
What Needs to Change for an ARM to Make Sense?
For ARMs to make more sense for people, the spread between fixed-rate and adjustable-rate mortgages would need to increase, which is more likely to happen when interest rates increase overall.
In any event, ARMs will still only make sense for a small subset for homebuyers and those who are looking to refinance. Here are a few situations when an ARM can make sense, if it represents a significant savings over a fixed-rate loan.
You’re Definitely Not Keeping the Loan Long Term
Many people’s careers allow them to expect and plan to relocate every so often. For people in this position, an ARM could be a cheaper option than a fixed-rate mortgage. Especially if you know you’ll have to move in the next 5-10 years.
But even in this circumstance, you’ll want to run the numbers. With an ARM you’re still responsible for closing costs. Closing costs can be 2%-6% of the loan amount, and for an average home that’s thousands of dollars you’ll pay upfront. If you’re only going to be in the home for a year or two, then it might be cheaper to rent than buy with any type of mortgage.
You Can Put the Extra Savings to Work for You
When the monthly savings of an ARM are significant, you may be able to put the extra savings to work.
The introductory period of an adjustable-rate mortgage – when the rate is at its lowest – can be an opportunity to increase your retirement savings, or to build your emergency fund. You could also take the money you’re saving and pay down your principal.
If you plan to pay off your mortgage in 10 years, an ARM with a 10-year introductory rate might be able to help you do that more easily. The extra equity you build can make it easier for you to refinance or save by waiving your private mortgage insurance requirement sooner.
There is a caveat to this approach: you need to be in a situation where if your rate increases, you can afford it. You can plan for this upfront because an ARM has limits on how much the rate can increase, at one time or over the life of the loan. If at any point you consider an ARM, make sure to ask your lender about these limits.
You’re Taking Out a Jumbo Loan
Jumbo loans are non-comforming loans because they exceed the dollar amount set by Fannie Mae and Freddie Mac. For 2020, the limit is $510,400 for most of the country, but it can be up to 150% higher in areas where homes are more expensive.
Because jumbo loans aren’t guaranteed by the government they are riskier for lenders and have stricter underwriting guidelines. This is why jumbo loans also have higher interest rates, compared to conforming loans.
Because of these higher rates, the spread between jumbo ARMs and fixed-rate loans can be bigger than with conforming loans. So you could save more during the introductory-rate period, but jumbo loans are, by definition, bigger loans. So any future rate increase on a jumbo ARM will have a bigger impact on your monthly budget.
Your Income Is Going to Increase
There are some situations where an ARM can make sense for high net worth or higher income households, McBride says. If you’re expecting a big increase in income, then an ARM might make sense for you. A doctor finishing her residency is a good example of someone this applies to.
The lower payment on an adjustable rate can offer flexibility if your income is variable or seasonal, he says. But again, he emphasized this only works in extreme cases, for example athletes or entertainers.