Fixed-Rate vs. Adjustable-Rate Mortgages Explained

A fixed-rate mortgage keeps the same interest rate for the entire loan, so the principal-and-interest payment never changes. An adjustable-rate mortgage (ARM) starts with a rate that is fixed for a set period, then resets periodically based on a market index. The ARM often starts cheaper. The price of that discount is uncertainty about what you will pay later.

This article is for home buyers and refinancers deciding between the two. You will learn what the ARM terms mean, how to read the three numbers in a cap structure, how a hypothetical $300,000 loan plays out under both options, and the questions to ask a lender before choosing.

How a fixed-rate mortgage works

With a fixed-rate loan, the Consumer Financial Protection Bureau (CFPB) says the interest rate is set when you take out the loan and will not change. Your principal-and-interest payment stays the same for 15, 20 or 30 years, depending on the term you choose.

Your total monthly housing cost can still move, because property taxes and homeowner's insurance are often collected in escrow with your payment, and those can rise. But the loan itself is predictable, which makes long-term budgeting simpler.

The trade-off is that a fixed rate is often higher than an ARM's initial rate. If market rates fall later, you keep your rate unless you refinance, which has its own closing costs.

How an ARM works

The CFPB explains that an ARM often starts below fixed-rate loans for a set introductory period, then adjusts at regular intervals, and payments are likely to rise after that period. The rate can go down as well as up, but some loans limit how far or how fast it can fall.

After the introductory period, your new rate is calculated from three parts:

• Index. An interest rate that moves with overall market conditions. The lender chooses it when you apply. The CFPB's current ARM booklet names SOFR (the Secured Overnight Financing Rate) as a common index, and your Loan Estimate shows which one applies to your loan.
• Margin. A fixed number of percentage points the lender adds to the index. It is set in your loan agreement and does not change after closing. Margins vary between lenders, so compare and negotiate them as you would a rate.
• Caps. Limits on how much the rate can move, covered below.

The CFPB gives a simple hypothetical: an index of 3% plus a margin of 2.5% gives a fully indexed rate of 5.5%, before any caps apply.

Reading "5/1" and "7/1"

ARM names describe the schedule. The first number is how long your initial rate lasts. In a 5/1 ARM, the rate is fixed for five years. In a 7/1 ARM, it is fixed for seven.

The second number is how often the rate adjusts afterward. A "1" means once a year. Some newer loans adjust every six months, and the CFPB booklet's sample loan is labeled 7/6 mo. for that reason. Always read the exact adjustment frequency on your Loan Estimate rather than assuming it is yearly.

A longer fixed period usually costs more in starting rate but gives you more years of certainty. If you expect to sell or refinance in five years, a 7/1 buys you two extra years of cushion in case plans slip.

The three cap numbers

Caps appear as a series such as 2/2/5. According to the CFPB:

1. Initial adjustment cap: the most the rate can change at the first adjustment. Common limits are 2% or 5%.
2. Subsequent adjustment cap: the most it can change at each later adjustment. Common limits are 1% or 2%.
3. Lifetime cap: the most it can change over the life of the loan. The most common limit is 5%.

So a loan starting at 5.75% with 2/2/5 caps could rise to 7.75% at the first reset, by up to 2 points at each later reset, and never above 10.75%. Some loans also have a floor, which sets a minimum rate. Ask whether yours does.

A worked example

The following numbers are hypothetical, and the rates are for illustration only, not current market rates. Say you borrow $300,000 for 30 years. A fixed-rate loan is quoted at 6.5%. A 5/1 ARM is quoted at 5.75%, with 2/2/5 caps.

The ARM saves about $145 a month, or roughly $8,730 over the five introductory years. After 60 payments your balance would be about $278,300. If the rate then resets to 7.75% on that balance over the remaining 25 years, your payment would be about $2,102, which is $206 a month more than the fixed loan. At that gap, the five-year savings would be used up in about 42 months.

The last row is an upper bound. It applies the 10.75% rate to the balance after year five, and the real balance would be somewhat lower by the time a rate that high was reached. It still tells you what to check: could your budget absorb a payment above $2,600?

Rates may not move this way at all. If the index falls, the ARM could cost less than the fixed loan for the entire term. The point of the exercise is to know both outcomes before you sign.

Side-by-side comparison

Who each loan tends to suit

A fixed rate generally fits buyers who plan to stay many years, have a tight monthly budget, or would lose sleep over a payment increase. It is also a reasonable default if you are unsure how long you will stay, since the risk is limited to a somewhat higher payment.

An ARM may fit buyers with a clear shorter horizon, such as a known job relocation, who could still afford the maximum payment the caps allow. The CFPB warns against counting on selling or refinancing before the rate changes, because home values can fall and your finances can change. If you are new to the process, our first-time homebuyer guide explains how lenders evaluate your income and debts.

Fine print to check

The CFPB lists several items to confirm before you sign an ARM:

• Adjustment schedule: many ARMs have a fixed initial period, often 3 or 5 years, then adjust about once a year, but check the exact frequency.
• Payment recalculation: payments usually update with each rate change, but some loans recalculate less often. If the rate rises and the payment does not, unpaid interest can be added to your balance.
• Negative amortization: confirm whether your balance can grow after closing.
• Floors and upward-only adjustments: these can raise your costs. Ask for a quote on a similar loan without them.
• Prepayment penalty: most loans have none, but verify.

Federal rules also require your servicer to notify you before a payment change. The CFPB booklet says that notice arrives seven to eight months in advance, which gives you time to shop for a refinance or adjust your budget.

Common mistakes

• Choosing on the starting payment alone. Look at the maximum payment under the caps.
• Assuming you can refinance later. Rates, home values and your credit can all change.
• Ignoring the margin. Two ARMs with the same starting rate can behave differently after reset if their margins differ.
• Comparing only rates. Compare APR, fees and points on Loan Estimates from several lenders.
• Not checking total housing cost. Taxes, insurance and HOA dues matter too, as our guide to renting vs. buying a home shows.

Frequently asked questions

Is an ARM always cheaper than a fixed-rate loan?

No. An ARM usually starts cheaper, but it can cost more over time if the index rises. Whether it ends up cheaper depends on how long you keep the loan and what rates do.

What happens when the introductory period ends?

Your rate resets to the index plus your margin, within the caps. Your payment is recalculated, and the servicer must give advance notice of the new amount.

Can I switch from an ARM to a fixed rate?

Usually by refinancing, which requires qualifying again and paying closing costs. Some loans have a conversion option. The CFPB suggests asking whether yours does and what the fee is.

Which index will my loan use?

The lender chooses it when you apply, and the choice generally does not change after closing. Your Loan Estimate shows it.

Next steps

1. Ask each lender for a fixed-rate quote and an ARM quote, along with the index, margin, caps and adjustment schedule.
2. Ask the lender to calculate the highest payment you could ever owe, and test whether your budget could handle it.
3. Decide how long you realistically expect to keep the loan, then compare total costs over that period.
4. Read the CFPB's consumer handbook on adjustable-rate mortgages before you sign.