Fixed Rate vs. Adjustable Rate Mortgage (ARM)

A fixed rate loan is one where the interest rate remains the same throughout the life of the loan. The advantage of a fixed rate is that the principal and interest portion of your payment will remain unchanged regardless of market conditions.

An adjustable rate mortgage (ARM) is a little more complicated. This is a loan where the interest rate is tied to an index of government securities, such as the one-year Treasury bill. What this means is that the rate can fluctuate (up or down) based on what interest rates are doing.

A Hybrid ARM is a combination of a fixed and adjustable rate mortgage. The rate remains fixed for a set period of time, then is allowed to adjust or float after that time. You will see this advertised as a “3/1 ARM”, a “5/1 ARM” or a similar title. The first number is the number of years that the fixed rate remains in effect after the loan is closed. The second number sets how often the rate can be adjusted after the fixed period of time elapses.

For example, a 3/1 ARM (or 3/1 Hybrid ARM) means that the interest rate will remain constant for the first three years of the loan. After that, the rate could be adjusted once per year.

The advantage of the ARM and Hybrid ARM is the possibility of a lower initial interest rate as compared to a fixed rate loan with the same term. Additionally, if interest rates decline, the rate could drop after the initial fixed rate period. Conversely, if rates rise, your interest rate could increase.

ARMs may be worth considering if you believe that interest rates will be lower in the future than they are now. If you are considering an ARM, you should ask yourself a few questions:

1. Do you think that interest rates are likely to rise or fall in the next few years?
2. How long do you plan to stay in your home? Will you exceed the fixed rate portion?
3. How does this rate compare to a fixed rate loan over the same term?
4. What is your current interest rate?  What is the actual savings in interest over the life of the loan if you refinance?  Keep in mind, you need to add in any costs you will be charged to refinance.  What is the savings in the monthly payment?
5. Be careful to look at the total costs you will be charged to refinance, and if you are considering a refinance, talk to at least two companies to compare costs and rates.  Be especially careful to ask about the discount points you will be charged, and compare that to offers from other companies.  There is nothing wrong with paying discount points; however, you need to decide if the interest rate you are getting for paying those points is significantly better than what you could get from another lender with fewer or no points.