ARM vs. Fixed-Rate Loans: When ARMs Make the Most Sense

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When buying a home or refinancing, you need to choose between a fixed-rate loan and an adjustable-rate mortgage (ARM) like a 10/1 ARM. The right choice depends on what you expect for the future and whether or not you can afford higher mortgage payments.

Fixed-rate loans are typically safest because they’re predictable, and your loan payment will not change. But you can often get a lower starting interest rate if you opt for an ARM. So, when does it make the most sense to choose an ARM over a fixed-rate mortgage?

Key Takeaways

  • When buying a home or refinancing, you need to choose between a fixed-rate loan and an adjustable-rate mortgage (ARM).
  • ARMs start with a low interest rate and relatively low payment, but fixed-rate loans are more predictable.
  • Using an ARM can pay off if you're planning to move soon, you're planning for a raise, you want to make an aggressive prepayment, or you're willing to take a risk.

4 Times to Consider an ARM

Although you risk higher monthly payments if rates rise, using an ARM can pay off.

1. Planning to Move

A classic example is when you plan to stay in your home for just a few years. In that case, an ARM can help you save on monthly payments. For instance, if you plan to move in six years, a 5/1 ARM or 10/1 ARM may be appropriate. With the 5/1 ARM, you risk one rate adjustment, but you’re planning to sell the house within a year of that adjustment, so you can evaluate a worst-case-scenario based on your loan’s rate caps. Situations like this include:

  • Mobile worker: If you have a career that requires periodic relocation, you might not need to secure a fixed rate for 30 years.
  • Starter home: If you buy a small first home with plans to expand later, an ARM can help you save on payments. Just remember that your plans may change, and there’s nothing wrong with living in an inexpensive home.
  • Preparing to downsize: If kids are moving out or you just want to simplify in the coming years, it may make sense to choose an ARM.

2. Planning for a Raise

It’s risky to bet on the future, but sometimes you can confidently expect to earn more. For example, doctors in residency may have limited funds and high student loan balances, but an ARM allows them to buy a more expensive house than they can afford with a fixed-rate loan. After residency, earnings typically increase, allowing them to comfortably handle higher payments or pay extra on the loan. Other professionals may have a similar experience after gaining experience or seniority, but it’s always wise to be conservative when planning for higher earnings.

3. Aggressive Prepayment

Some people don’t like to let their debt linger. If you plan to pay off your mortgage quickly, a 5/1 ARM provides a relatively low rate (and low monthly payment) for at least five years. During that time, anything you pay on top of the required payment reduces your loan balance. A slightly less-aggressive approach is to choose a 10/1 ARM if you plan to pay off your debt in five to ten years—you can do so without risking payment shock.

4. Willing to Take Risk

If you’re open to the risk of higher payments, it may be worth having a low rate for a few years. For example, you might believe that interest rates are going to stay the same or fall (although nobody can predict the future). But if rates rise, you need to be able to absorb those higher payments. That strategy might make sense if you’re fortunate enough to have plenty of extra income each month—and if that remains the case over the years.

When Do Fixed-Rate Mortgages Outshine ARMs?

If you want (or need) safety, a fixed-rate mortgage can be your best option. The rate won’t change, so you can predict your housing expenses for the next 15 or 30 years. If you don’t want to make mortgage payments for that long, you can always pay extra or sell your home to pay off the loan.

Payment Shock

It’s critical to understand that your payment can rise with an ARM. If your housing payments take up a significant portion of your income, you probably don’t have room for a higher payment in your budget. The consequences of a higher payment range from being “house poor” to facing foreclosure and ruining your credit.

Minimizing Interest Costs

If your goal is to pay as little interest as possible, a short-term fixed-rate mortgage is typically best. For example, 15-year fixed-rate loans may have lower rates than 5/1 ARMs, so you pay less interest with the fixed-rate loan from the beginning. However, a 15-year mortgage requires a higher payment, and there’s no flexibility if cash flow gets tight. With a 5/1 ARM, you’ll also have a relatively low payment, and you can pay extra toward your mortgage only when you have funds available. Compared to the aggressive repayment described above, the 15-year loan has lower interest costs—but you’re required to make a sizeable payment every single month.

“Stretching” to Buy

If you base your decision on a fixed-rate loan vs. an ARM solely on the monthly payment, you’re taking a risk. 30-year fixed-rate mortgages are popular because they allow for relatively low monthly payments, and trying to shave even more off the payment means it’s time to look at lower-priced homes. Remember that homeownership comes with numerous costs, and you need to budget for maintenance, furnishings, energy, taxes, insurance, and more. Venturing onto thin ice can end badly for you and your family—there’s no room for error.

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