ARM vs Fixed Mortgage: What’s the Difference?

Stability and predictability, or a shot at potential savings – these are two key factors your clients weigh when choosing a mortgage. This is where two main players come in: fixed-rate mortgages and adjustable-rate mortgages (ARMs). Fixed-rate mortgages firmly lock in the interest rate for the entire term of the loan, offering stability and consistent monthly payments. ARMs, on the other hand, provide a lower introductory rate initially, but this rate adjusts periodically based on market conditions, causing monthly payments to fluctuate. Let’s explore an in-depth comparison of ARM vs. fixed-rate mortgages and find out which type may be more suitable based on various financial circumstances and market conditions.

What is an ARM?

[cta4]

Adjustable-rate mortgages (ARMs) are home loans designed to offer borrowers a sweet spot of affordability upfront, with some built-in flexibility. ARMs come with a fixed introductory period (often 3, 5, 7, or 10 years). During this time, a homebuyer benefits from a competitively low, locked-in rate, potentially saving money on their monthly payments. However, after the introductory period ends, the ARM’s magic trick unfolds. The interest rate adjusts periodically, typically once a year, based on a market index. So, if interest rates rise in general, borrower’s ARM rates will likely climb as well, potentially increasing their monthly payment. Conversely, if interest rates fall, borrower’s ARM rates could adjust downward, keeping their payments manageable.

The mechanism behind ARMs involves two key components: the index and the margin.

The index is a benchmark interest rate reflecting market conditions, like the now-phased-out LIBOR (London Interbank Offered Rate), replaced by SOFR (Secured Overnight Financing Rate) for its reliability and transparency. The margin is a fixed percentage added to the index to determine the fully indexed interest rate. For instance, if the index is 2% and the margin is 2.5%, the rate would be 4.5%.

The transition from LIBOR to SOFR impacts ARM borrowers, as SOFR is based on actual Treasury repurchase market transactions, offering more stability. Existing ARMs are moving to SOFR, potentially changing interest rates and payments. ARM rates adjust after an initial fixed period and include caps to limit rate changes, helping borrowers manage fluctuations.

Types of ARMs

Depending on the length of the introductory period and the frequency of rate adjustments, there are different ARM options. The most common are the 3/1 ARM, 5/1 ARM, 7/1 ARM, and 10/1 ARM. The first number here signifies the introductory fixed-rate period (3, 5, 7, and 10 years), and the second number represents the frequency of rate adjustments after that initial period (in the above cases, every year). For example, in the case of 5/1, the interest rate is fixed for the first five years (the introductory period) and then adjusts every year (the adjustment period) thereafter.

There is also the hybrid type of ARM that combines features of both fixed-rate and adjustable-rate mortgages. Another type of ARM is the interest-only (I-O) ARM. This option allows borrowers to pay only the interest on the loan during the introductory period. Once the introductory period ends, the payment adjusts to cover both the interest and principal, which can result in a much higher monthly payment. There is also a payment-option ARM that offers borrowers more flexibility in their monthly payments. Borrowers can choose to make a full payment, a minimum payment that covers only the interest (similar to an I-O ARM), or a fixed payment amount that may not fully cover the interest during the introductory period. The advantage is the ability to manage cash flow, but the risk is that the principal balance can increase significantly if minimum payments are made consistently.

The main advantage of ARMs is their lower initial interest rates, which can make them attractive to borrowers who want to minimize their early mortgage payments.

What is a Fixed-Rate Mortgage?

A fixed-rate mortgage is a type of home loan where the interest rate remains constant throughout the entire term of the loan. This means that the monthly principal and interest payments don’t change, providing stability for homeowners. Because your client knows exactly what their monthly payment will be from day one to the very last, one of the main benefits of a fixed-rate mortgage is the predictability it offers. This can provide a sense of security and peace of mind, knowing that their housing costs will remain consistent over the long term.

Another benefit is that fixed-rate mortgages offer protection against rising interest rates. Even if market interest rates increase, borrowers with fixed-rate mortgages are shielded from higher payments, allowing them to maintain financial stability.

Additionally, fixed-rate mortgages simplify financial planning and make it easier to understand the long-term cost of homeownership. Unlike adjustable-rate mortgages, where monthly payments can change over time, a fixed-rate mortgage ensures that homeowners know exactly what to expect month after month, year after year.

What’s more, the benefits go beyond consistency and planning. Fixed-rate mortgages can simplify the qualification process. Lenders can more easily assess a borrower’s ability to repay the loan with a clear picture of their long-term financial obligations. This can be especially advantageous for clients with limited credit history or those seeking a larger loan amount.

Key Differences: ARM vs Fixed-Rate Mortgage

When it comes to ARM vs fixed-rate mortgage, making the right decision is important for any homebuyer. And there are several key differences to consider before guiding your clients to the perfect fit. Let’s break them down.

Interest Rates

The most obvious difference between ARMs and fixed-rate mortgages is how their interest rates are determined. Fixed-rate mortgages have a set interest rate agreed upon at the start, while ARMs begin with a lower rate that adjusts periodically. As mentioned earlier, these adjustments are typically based on a benchmark or index, such as the LIBOR or Treasury Bill rates.

Payment Changes Over Time

With a fixed-rate mortgage, the borrower’s monthly payments remain constant throughout the loan term. This predictability helps with long-term financial planning. On the other hand, ARMs can lead to varying payment amounts after the initial fixed period. If market interest rates rise, so will the borrower’s monthly payments, potentially making budgeting more challenging.

Pros and Cons in Different Market Conditions

Fixed-rate mortgages are beneficial in a stable or rising interest-rate environment. They protect borrowers from future rate hikes and ensure consistent payments. However, in a declining rate market, fixed-rate mortgage holders may miss out on lower rates unless they refinance.

ARMs are advantageous when interest rates are falling or stable, as borrowers benefit from initially lower rates and potentially lower payments in the future. However, they pose a risk in a rising rate environment, as future payment increases could strain borrowers’ finances.

Comparison of Costs and Payments: ARM vs Fixed-Rate Mortgage

As you’ve already learned, ARMs and fixed-rate mortgages come with different payments and costs. To better understand these differences, let’s look at a scenario.

For example, if a borrower takes out a 30-year fixed-rate mortgage for $300,000 at an interest rate of 4%, their monthly principal and interest payment would be approximately $1,432. A 5/1 ARM, for example, may have an initial interest rate of 3% for the first 5 years, after which it adjusts annually. Using the same $300,000 loan amount, the initial monthly payment for the 5/1 ARM would be approximately $1,265.

Now, let’s consider the effect of interest rate changes. If interest rates rise, the monthly payments for an ARM will increase when it adjusts after the initial fixed period, potentially creating a financial burden. In contrast, with a fixed-rate mortgage, payments remain unaffected by interest rate fluctuations, offering peace of mind and budget stability. To illustrate this further, let’s imagine a scenario where interest rates rise by 1%. For the 5/1 ARM example, the monthly payment would increase to approximately $1,381 after the initial 5-year period, resulting in a jump in expenses. On the other hand, the payment for the 30-year fixed-rate mortgage would remain at $1,432, unaffected by the interest rate hike.

Who Should Choose an ARM?

ARMs may be appropriate for borrowers who expect their income to increase over time or who plan to sell or refinance before the end of the initial rate period. For instance, young professionals anticipating career advancements or military personnel expecting frequent relocations could benefit from the lower initial payments of an ARM.

Here are some common financial profiles that can benefit from ARMs:

• Young professionals

Those in the early stages of their careers may choose an ARM to take advantage of lower initial payments, with the expectation that their income will grow, allowing them to handle potential rate increases later.

• Frequent movers

If your client expects to move within a few years, the lower initial rate of an ARM can save money and minimize the likelihood of encountering rate adjustments.

• Real estate investors

Investors who plan to sell the property within the ARM’s fixed period can benefit from lower rates without worrying about long-term adjustments.

Who Should Choose a Fixed-Rate Mortgage?

Fixed-rate mortgages are ideal for those who prefer stability and predictability in their payments. Borrowers with steady incomes who plan to stay in their homes for the long term, such as families or retirees, may find the fixed-rate mortgage attractive.

Here are some common ideal candidates for fixed-rate mortgages:

• Long-term homeowners

Families planning to stay in their homes for many years often prefer the stability of a fixed-rate mortgage.

• Retirees

Those on fixed incomes benefit from the predictable payments, avoiding the risk of increased living expenses due to rising mortgage rates.

• Risk-averse borrowers

Individuals who prioritize financial security and want to avoid the uncertainty of future rate changes are better suited for fixed-rate mortgages.

How to Decide: ARM vs Fixed-Rate Mortgage

To help your clients decide between an ARM and a fixed-rate mortgage, you’ll need to consider and analyze factors such as their financial stability, the housing market, and their future plans. Let’s take a closer look at each of these factors.

• Financial stability

If your client’s income is stable and they prefer predictable expenses, a fixed-rate mortgage may be better. If they anticipate higher future earnings or plan to move within a few years, an ARM could be advantageous.

• Housing market

In a low or declining interest rate environment, an ARM could save money. Conversely, in a rising rate environment, a fixed-rate mortgage offers protection against payment increases.

• Future plans

If your client plans to sell or refinance within a few years, the lower initial rates of an ARM may be beneficial. For long-term stays, the stability of a fixed-rate mortgage may be more appropriate. Refinancing the borrowers existing loan, may increase total finance charges over the life of the loan.

Tips on matching mortgage type to financial goals

As a mortgage broker, you can effectively match borrowers with the right mortgage type. Ask about their financial cushion, their comfort level with risk, and their long-term vision for the home. Run various scenarios to show the impact of potential interest rate changes on both ARMs and fixed-rate mortgages. Remember, transparency builds trust, and an informed borrower is a confident borrower.

Conclusion

Seeing the differences between ARM vs fixed-rate mortgages is critical for homebuyers to make informed decisions. Fixed-rate mortgages offer stability with a consistent monthly payment, shielding clients from market fluctuations. This can be particularly appealing to those who prioritize financial predictability and have long-term homeownership goals. On the other hand, ARMs provide a lower initial interest rate, potentially leading to significant savings in the early years. This can be a strategic choice for clients who anticipate higher future income, plan to move within a few years, or want to take advantage of the initially lower rates. Advising clients on which mortgage type fits their financial situation and future plans can make a significant difference in their homeownership experience. Encourage your clients to thoroughly evaluate their financial stability, the current housing market, and their long-term goals.