Fixed vs. Adjustable Rates

What is a fixed-rate mortgage?

A fixed-rate mortgage is a home loan whose interest rate is set when you take out the loan and doesn't change. Your monthly principal and interest payment stays the same too.

Your total monthly payment can still change. It can go up or down if your property taxes, homeowner's insurance or mortgage insurance changes.

The CFPB says most borrowers choose a fixed-rate mortgage. Payments are more likely to be stable, which can appeal to people who value certainty about their loan costs over the long term.

Sources: Consumer Financial Protection Bureau, "Understand the different kinds of loans available"; Consumer Financial Protection Bureau, "What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?"

What is an adjustable-rate mortgage?

An adjustable-rate mortgage, or ARM, is a home loan whose interest rate can go up or down. Most ARMs have two periods.

In the first period, the rate is fixed and won't change. Many ARMs start at a lower rate than fixed-rate mortgages. This starting rate may stay the same for months or for years.

In the second period, the rate goes up and down at regular times based on the market. Your monthly principal and interest payment could go up a lot.

Sources: Consumer Financial Protection Bureau, "What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?"; Consumer Financial Protection Bureau, "Understand the different kinds of loans available"

How does an ARM's interest rate change?

An ARM's interest rate changes based on an index plus a margin, subject to any rate caps. The index is an interest rate that moves with general market conditions.

The margin is a number of percentage points the lender adds to the index. It's set in your loan agreement and won't change after closing. Margins can vary a lot from one lender to another.

The lender picks the index when you apply, and that choice generally won't change after closing. Once the rate starts to adjust, changes are based on the market, not your personal finances. If interest rates go up, your payments go up.

Sources: Consumer Financial Protection Bureau, "For an adjustable-rate mortgage (ARM), what are the index and margin, and how do they work?"; Consumer Financial Protection Bureau, "What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?"

What are rate caps on an ARM?

Rate caps are limits on how much an ARM's interest rate can change. The CFPB describes three kinds.

An initial adjustment cap limits the first change after the fixed-rate period ends. A subsequent adjustment cap limits each change after that. A lifetime adjustment cap limits the total change over the life of the loan.

Some loans have a separate lifetime limit on how far the rate can drop, called a floor. Two lenders may offer the same starting rate but different caps.

Sources: Consumer Financial Protection Bureau, "What are rate caps with an adjustable-rate mortgage (ARM), and how do they work?"; Consumer Financial Protection Bureau, "What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?"

What does the CFPB say to check before taking an ARM?

The CFPB lists several things to check before taking out an ARM. They include how high or low your rate and payment can go with each change, how often the rate adjusts and how soon your payment could go up.

The list also asks whether there's a cap or a floor, and whether you could still afford the loan if the rate and payment rose to the most the contract allows. Your Loan Estimate shows the highest payment you may have on the loan.

The CFPB warns not to assume you'll be able to sell your home or refinance before the rate changes. Your home's value could drop, or your finances could change.

An ARM could cost less in the short term, for example for someone who moves within the fixed period. If you stay longer than you expected, you could end up paying a lot more.

Sources: Consumer Financial Protection Bureau, "What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan?"; Consumer Financial Protection Bureau, "Understand the different kinds of loans available"; Consumer Financial Protection Bureau, "What are rate caps with an adjustable-rate mortgage (ARM), and how do they work?"