What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?
The difference between a fixed rate and an adjustable rate mortgage loan is that for a fixed rate loan, the interest rate is set when you take out the loan and will not change. With an adjustable rate loan, the interest rate may go up or down.
With a standard fixed rate mortgage loan, your monthly principal and interest payment is set when you take out the loan and will not change over the life of the loan (although your total payment could change because of taxes and insurance). With an ARM, your monthly payment could change—by a lot.
Many ARMs will start at a lower interest rate than a fixed rate mortgage. This initial rate may stay the same for months or years. When this introductory period is over, however, your interest rate will change and the amount of your payment will likely go up.
Part of the interest rate you pay will be tied to a broader measure of interest rates, called an index. Your payment goes up when this index of interest rates moves higher. When the index declines, sometimes your payment may go down, but that is not true for all ARMs. Your mortgage payment could go up even if the interest rate index doesn’t go up because many ARMs will limit the amount of each adjustment. ARMs may set a maximum, or “cap,” on how high your interest rate can go over the life of the loan. Some ARMs also limit how low your interest rate can go.
If you are considering buying a home using an ARM, don't assume you’ll be able to sell the home or refinance your loan before the rate adjusts at some future date. The value of your property could decline or your financial condition could change. If you can’t afford the higher payments on today’s income, you may want to consider another type of loan.