Fixed-Rate Mortgage vs. ARM: How Do They Compare? | Charles Schwab

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Fixed-Rate Mortgage vs. ARM: How Do They Compare?

March 16, 2017

For most people, buying a home means committing to more than just a particular house. It also means taking on the obligations that come with a mortgage. Finding a mortgage that fits your situation can have a big impact on your future financial well-being. That’s why it’s important to think strategically—particularly when rates have been near record lows for years, but may be rising. 

Let’s look at how two different types of mortgages—fixed-rate and adjustable-rate—can serve different types of borrowers—and what rising rates may mean for each type of loan.

Fixed-rate mortgages

A fixed-rate mortgage locks in both your interest rate and monthly payments for the life of your loan—offering the peace of mind that comes with stability. This is the most traditional form of a mortgage. 

Here are reasons to consider a fixed-rate mortgage:

  • Flexible term potential. You can opt for a shorter-term loan that will allow you to pay it off more quickly.
  • Predictable budgeting. Your repayment obligations will be clear.
  • Interest rate assurance. Your principal and interest payment will hold steady if interest rates change. 

Indeed, fixed rate mortgages can be appealing if you think rates are lower now than they will be in the future. With rates near historical lows, locking in a rate could make sense for many borrowers now.

Adjustable-rate mortgages

An adjustable-rate mortgage (ARM) has a fixed interest rate for a specified initial term—generally five, seven or 10 years. Once this initial fixed rate period ends, your monthly payments will vary as market rates change. 

ARMs generally have lower initial monthly payments. As a result, an ARM might make sense if you would like greater cash-flow flexibility in the near term.

However, there are a number of important considerations with ARMs. With this type of loan, remember, your monthly payments may increase once the initial fixed-rate period has ended.  Be sure that you can afford the mortgage payments at higher rates and don’t buy more house than you can afford just because of low initial mortgage payments.

This is particularly relevant if mortgage rates rise—which may happen if interest rates rise from their current historic lows. 

Here are reasons to consider an ARM:

  • Lower initial rate. The interest rate during the initial fixed period is generally lower than what you would get with a fixed-rate mortgage, which can save you money over the short term. Keep in mind, however, that you should factor in the ability to afford an increase in mortgage payments if rates rise.
  • Interest rate caps. To protect you against rising interest rates, many ARMs offer limits on how much your rate might increase in a given adjustment period or over the life of the loan.
  • Interest-only options. Some ARMs offer an interest-only payment option to lower your initial monthly payments even further, allowing for even greater cash-flow flexibility over the initial term. However, it is important to remember that during the initial interest-only period, your minimum monthly payments will not reduce your loan principal unless you choose to pay more than the minimum billed payment amount.1 And at the end of the initial fixed-rate period, your payments could rise. 

Bottom line

These two types of mortgages can be attractive for different situations. Do you want to lock in a historically low fixed interest rate now? Or are you interested in potentially maximizing cash flow in the short term with the trade-off that your payments may rise after the initial fixed mortgage period ends? These are important—and timely—points to consider. If you’re planning to buy a house this home-buying season, take some time to think strategically about what will work best for you.  

1Interest-only mortgages have an initial interest-only payment period followed by a fully amortizing payment period. After the interest-only period ends, your monthly payments will increase because you will be paying both principal and interest.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. Please consult with your tax advisor on the deductibility of home equity line of credit interest payments for your specific tax situation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers are obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed.

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