Should you get a fixed-rate or adjustable-rate mortgage?

A fixed-rate mortgage keeps the same interest rate and principal and interest payment for the whole loan, while an adjustable-rate mortgage (ARM) starts lower and then moves with the market. Pick an ARM only if you could still afford the highest payment its caps allow.

Fixed means the rate is locked for the loan

With a fixed-rate mortgage, the interest rate is set when you take out the loan and will not change. Your principal and interest payment is the same in month 1 and month 360.

An ARM has a starting period, then resets

Many ARMs start at a lower rate than a fixed loan. That rate holds for months or a few years. After that, the rate changes on a regular schedule, and your payment is likely to go up.

Caps limit each jump and the total

Most ARMs have three caps: one for the first change, one for each change after that, and a lifetime cap. A common lifetime cap is 5 percentage points above the starting rate.

The Loan Estimate shows the risk

Lenders must give you a Loan Estimate within three business days of your application. For an ARM, it shows how the rate and payment can change and the highest payment possible.

How a fixed-rate mortgage works

A fixed-rate mortgage has one interest rate for the whole loan. On a 30-year loan, you make 360 equal payments of principal and interest. Early payments are mostly interest. Later payments are mostly principal. The total of the two never changes.

Your full monthly bill can still move. If your lender collects property taxes and homeowners insurance through an escrow account, those amounts change when your tax bill or premium changes. The loan part stays put.

You usually pay a somewhat higher starting rate than an ARM in exchange for knowing your payment for decades. If rates fall later, you can try to refinance. If rates rise, you keep your rate.

How an adjustable-rate mortgage works

An ARM starts with an introductory rate that holds for a set time. In a 5/1 ARM, that is 5 years, then the rate adjusts once a year. A 5/6m ARM also holds for 5 years, then adjusts every 6 months.

When the starting period ends, the new rate is the index plus the margin. The index is a market interest rate that moves on its own. The margin is a set number of percentage points the lender adds, written into your loan agreement. If the index is 4% and your margin is 2.75%, your new rate would be 6.75%, as long as the caps allow it.

Because the index follows the market, your rate can rise even if your credit and income are perfect. Some ARMs also have a floor, which stops the rate from falling below a set level when rates drop.

How rate caps work

Caps are the guardrails on an ARM. The initial adjustment cap limits the first change, often 2 or 5 percentage points. The subsequent adjustment cap limits each later change, often 1 or 2 points. The lifetime cap limits the total rise over the loan, most often 5 points above the starting rate.

Lenders often write caps as three numbers, like 2/2/5. On a loan that starts at 5.75%, a 2/2/5 cap means the rate could be 7.75% after the first change, 9.75% after the second and never above 10.75%.

The lifetime cap is the number that matters most for safety. Multiply it out with a calculator so you see the real dollar payment at that rate, not just a percentage.

When each one fits

A fixed rate fits most first-time buyers. It suits you if you plan to stay in the home for many years, your budget has little slack, or you would lose sleep over a payment that can change.

An ARM can make sense in a narrower set of cases. You expect to move before the starting period ends, for example with a job that relocates you every few years. You can afford the worst-case payment today. You have savings left after closing. Even then, the CFPB warns not to assume you will be able to sell or refinance before the rate changes, because home values and your finances can change.

If an ARM is the only way the payment fits, treat that as a sign the house may cost more than your budget allows right now.

Questions to ask a lender about an ARM

Ask how long the starting rate lasts, how often the rate adjusts after that, which index it uses and what the margin is. Ask for each cap and whether there is a floor.

Then ask for the highest monthly payment you could ever owe and the earliest date it could arrive. Check whether the loan has a prepayment penalty, which would make refinancing out of the ARM more expensive. All of this should appear on the Loan Estimate.