Since most of us don't have the cash on hand to pay for our homes outright, signing a mortgage is practically a given for would-be homeowners. But not all mortgages are created equal, and while most homebuyers opt for a traditional fixed-rate loan, you may be tempted to go with an adjustable-rate mortgage instead.
An adjustable-rate mortgage, or ARM, is a home loan whose interest rate is subject to change over time. Whereas the interest rate on a fixed-rate mortgages is set in stone, the rate on an ARM can go up or down depending on market conditions. While adjustable-rate mortgages come with certain benefits, they don't offer the same degree of security as fixed loans.
Adjustable- versus fixed-rate mortgages
Fixed-rate mortgages have long been the standard in the homebuying industry, and borrowers tend to like them because they're fairly straightforward. When you sign a fixed mortgage (which typically comes in a 15- or 30-year term), you're locking in a predetermined interest rate for the life of your loan. This means your monthly payments will always be predictable, and you won't have to worry about facing an increased rate.
Adjustable-rate mortgages work differently. With an adjustable-rate mortgage, you're given an initial rate that you'll pay for a preset period of time -- typically five years. Once that period ends, however, your rate will fluctuate year after year depending on where prevailing interest rates go. If rates start climbing, your monthly payments will go up as well. On the other hand, if rates start falling, you might see your monthly mortgage payments go down.
Benefits of adjustable-rate mortgages
The main reason to consider an ARM is that, generally speaking, the interest rate you're offered during your loan's initial period will be lower than the going rate for fixed loans. If you sign up for a 5/1 ARM, which is a popular choice among borrowers, you'll typically benefit from a reduced rate for the first five years of your loan. Once that period expires, however, your rate will adjust every year going forward. But if you're only planning to stay in your home for five years, then signing up for a 5/1 ARM is a good way to lock in a lower interest rate during that time.
Another potential benefit of getting an ARM is that your interest rate might drop over time. When this happens, your monthly payments will be lowered as well.
Drawbacks of adjustable-rate mortgages
The fact that the interest rate on an ARM changes over time can be both a blessing and a curse. If you're lucky, you'll see your rate go down once you've had your loan for a number of years. On the other hand, if rates start to climb across the board, yours is bound to go up, and with that, so will your monthly payment.
If you're only planning to stay in your home for a short period of time, there's a chance you won't get hurt by fluctuating rates. That's because ARMs typically impose limits on the extent to which rates can change year after year. But if you're expecting to hang on to your loan for many years, you'll be taking a pretty substantial risk, as long-term interest rates can be fairly unpredictable.
Adjustable-rate or fixed-rate mortgage: What's right for you?
If you're wondering whether you'll come out ahead with an adjustable-rate mortgage or a fixed-rate mortgage, we have a tool that can help. This calculator will let you run different scenarios to help you arrive at the best choice.
Ultimately, the decision to go with an ARM or not might boil down to your appetite for risk. If you're the type of person who needs the security that comes with predictable payments, then you're probably better off opting for a fixed loan. But if you're willing to roll the dice, an adjustable-rate mortgage could be the right move for you.