Fixed vs Adjustable-Rate Mortgages in Plain Words

One of the first choices on a mortgage application is whether the interest rate will stay put or move. The Consumer Financial Protection Bureau puts it simply: with a fixed-rate mortgage, the interest rate is set when you take out the loan and will not change. With an adjustable-rate mortgage, or ARM, the interest rate may go up or down. Everything else about the decision follows from that difference.

1. How a fixed-rate mortgage works

With a fixed rate, the principal and interest part of your payment is the same from the first month to the last. Property taxes and insurance can still change, so your total monthly payment may move, but the loan part does not. You trade a possibly higher starting rate for certainty.

2. How an adjustable-rate mortgage works

The CFPB explains that many ARMs start at a lower interest rate than fixed-rate mortgages. That introductory rate may last months, one year, or a few years. When the introductory period ends, the rate changes at regular intervals, and the CFPB notes that your payment is likely to go up.

The new rate is not picked at random. It is set by a formula:

Index + Margin = Your interest rate (subject to any rate caps)

• The index is an interest rate that moves with general market conditions. The lender chooses which index your loan uses when you apply, and that choice generally will not change after closing.
• The margin is a number of percentage points the lender adds to the index. It is set in your loan agreement and will not change after closing.

The CFPB adds a useful tip: margins can vary a lot between lenders, and you can negotiate the margin just as you would negotiate the rate on a fixed-rate loan. The index plus the margin is called the fully indexed rate.

3. Rate caps

Some ARMs limit how much the rate can rise at any one adjustment or over the life of the loan, and some also limit how far it can fall. The CFPB notes that the cap on the first adjustment may differ from the caps on later adjustments. Your actual rate at each reset is the index plus the margin, held within any caps.

4. A worked example

Assume a $300,000, 30-year loan. The numbers below are illustrative only, not quotes.

• Introductory rate: 6.00% for the first 5 years
• Margin: 2.75 percentage points
• Index at the first reset: 4.00%, so the fully indexed rate is 6.75%
• Assumed caps: up to 2 points at the first adjustment, 5 points over the life of the loan

During the first five years, the principal and interest payment is $1,798.65. After 60 payments, about $279,163 is still owed. At the reset, the remaining balance is spread over the remaining 25 years at the new rate:

The last row is the number worth staring at. The CFPB suggests finding out how high your rate and payments could go, whether there is a cap, and whether you could still afford the loan if the rate and payment rose to the maximum allowed under the contract.

5. The assumption to avoid

The CFPB warns against assuming you will be able to sell or refinance before the rate changes. Home values can decline and your finances can change. If you could not afford the higher payment on today's income, the CFPB suggests you may want to consider another loan.

6. Where to see it on your Loan Estimate

Page 1 of the Loan Estimate has a line asking whether the interest rate can increase after closing. According to the CFPB, if that column says "YES," your rate is adjustable. Adjustable-rate loans also show extra information in the Projected Payments table on page 1 and in two additional tables at the bottom of page 2. Check that the loan type matches what you expected before you go further.

7. Which one fits

There is no universally better choice. A fixed rate suits a buyer who wants a stable payment and expects to stay a long time. An ARM can cost less early on, which some borrowers use when they have a clear, realistic reason to expect a shorter stay, and when they can absorb the payment at the cap. Compare both on the same Loan Estimate basis, and run the worst case, not just the first payment.

8. Key takeaways

• A fixed-rate mortgage keeps the same interest rate for the life of the loan; an ARM's rate can go up or down after an introductory period.
• An ARM's new rate is the index plus the margin, subject to caps; the margin is fixed at closing and can be negotiated.
• On the $300,000 example, the payment rises from $1,798.65 to $1,928.77 at a 6.75% reset, and to $2,736.11 if the rate reaches 11%.
• Do not count on selling or refinancing before a reset.
• Your Loan Estimate shows whether the rate can increase and includes extra adjustable-rate tables.