Purchase, Homebuying 101, First time homebuyer, Finding a home
ARMs vs. Fixed Conventional Loans
What you'll learn: How to Compare an Adjustable-Rate Home Loan to a Fixed Conventional.
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April 1, 2022
The two most common loans you will find are adjustable-rate mortgages (ARMs) and fixed-rate conventional loans. These two types of loans have some general commonalities between them. Both types of mortgages provide you with a long-term loan of 15, 20, or 30 years. But from there, they begin to differ. And those differences can mean thousands of dollars in what a borrower eventually pays. We will go through both types of mortgages, explaining the positives and negatives of each. That will help you decide which one is best for you.
ARMs Pros & Cons
Adjustable-rate mortgages come in several varieties. But the main thing you need to know is that these loans have a fixed interest rate period and a variable rate period. When you see the type of ARM listed, it will look like this "#/#m" you will have a number with a slash "/" and a second number (or a number and an "m")
So a 5/6m ARM will have a five-year fixed-rate period. And then, for the remainder of the loan, it will have a floating rate that changes every six months. That is called the adjustment period. The rate that is used for the adjustment period will use the index rate called the Secured Overnight Financing Rate (SOFR) and is almost always based on this formula:
30 day average of SOFR (Index) + (Margin)
A typical margin will usually range from 2.74% to 2.76%. The margin stays constant, but the SOFR index's value varies.
The New York Federal Reserve maintains the SOFR index, and you can access the current rates here. In early 2022 the 30-day average was 0.0487%.
When we look at example ARM rates, we see their most significant advantage is they are lower than a fixed-rate mortgage.
ARMs rates are for the fixed period, then adjust
You can see ARM mortgage trends here.
While the difference between a fixed rate of 4.25% and a 10/1m ARM at 3.375% is less than one percent, that can be a considerable amount of actual dollars when talking about a mortgage.
However, when the fixed rate expires and the calculated adjustment period rate is higher, then the monthly mortgage payment will go up. There is a cap to the possible increase (discussed below), but it can still be significant for a borrower unprepared for it.
Fixed-Rate Pros & Cons
The fixed-rate mortgage is much easier to understand than an ARM. Once you have locked in your rate, you will have that same rate for the length of the mortgage; this is usually 15 to 30 years.
However, the speed at which you are paying off the mortgage is also faster. You will therefore have a higher monthly payment.
With a fixed rate, your payment will stay the same for the entire term of the loan, never changing. This attribute can be both a pro and a con. If you are buying a home when interest rates are high, you will have that high rate for the entire term of the loan. That is a negative.
If you buy when rates are low, you can take advantage of those low rates for the entire term of the loan. That is an obvious positive.
Because we have had low rates for the past few years, fixed-rates loans have been prevalent.
Critical Differences Between Adjustable & Fixed
The critical difference between an adjustable and fixed-rate mortgage is that a fix-rate is "fixed" for the loan's entire term. An adjustable-rate loan will have a fixed period that begins the loan – and then shift to its adjustment period.
The adjustment period is when the loan rate will go up and down depending on the SOFR index at the time. The change in the upward direction has a cap, so you will know the worst-case scenario if rates are rising.
The Three ARM Caps
Three caps occur starting immediately after the fixed period ends. According to the Consumer Finance Protection Bureau, these are the most common adjustment amounts:
1. 2% to 5% for the initial adjustment cap – is the most common amount your rate will increase when you move from the fixed-rate period to the adjustable-rate period.
2. 2% for subsequent adjustment cap – is the most common amount your rate will increase after each adjustment period.
3. 5% for the lifetime adjustment cap – is the most common amount your rate will increase above your initial fixed rate for the life of the loan.
Knowing what the caps are of the loan you’re considering is vital. That way, you can see the maximum interest in the worst-case scenario.
Which is Right for You – Fixed or Adjustable?
The best rule of thumb for choosing between an ARM and a fixed-rate mortgage is how long you plan to stay in your new home. If there is a good chance that you will move within three to ten years, then choosing an ARM may be the best option.
But, if you’ve found your dream home and plan to stay forever, then a fixed-rate mortgage could be your best choice.
Fixed & ARM Rates are Still Low
Which mortgage you choose will affect your monthly payment in the beginning and for the life of the loan. Fortunately, loan rates are still historically low. And with the caps on ARMs, you know the worst-case scenario. And if you are planning to move within three to ten years, then an ARM is a good bet.
As we get older, we are less likely to move, and a fixed rate will ensure that your payment stays the same for the duration. So, if you’re downsizing and heading to retirement, keep that in mind.