One of the first choices you make when you get a mortgage is whether the interest rate stays the same for the life of the loan or can change over time. Each option has trade-offs. This guide explains how fixed-rate and adjustable-rate mortgages (ARMs) work, what the terms in ARM offers mean, and which questions to ask before you choose.
How a fixed-rate mortgage works
With a fixed-rate mortgage, the CFPB explains, the interest rate is set when you take out the loan and doesn't change. Your principal-and-interest payment stays the same from the first payment to the last, and it follows a standard amortization schedule. (Your total payment can still change if property taxes or insurance in escrow go up or down.)
The main advantage is predictability. You know the core payment for as long as you keep the loan, regardless of what happens to interest rates. The trade-off is that fixed-rate loans often start at a higher rate than the introductory rate on a comparable ARM. If rates fall later, a fixed-rate borrower only benefits by refinancing, which has its own costs.
How an adjustable-rate mortgage works
With an ARM, the interest rate can go up or down over the life of the loan. According to the CFPB, many ARMs start with a lower rate than fixed-rate loans. After that initial period ends, the rate adjusts at set intervals, and payments often rise.
Index and margin
After the initial period, an ARM's rate is generally based on two numbers:
- The index is a benchmark interest rate that reflects broader market conditions. Your loan documents name the index your loan uses.
- The margin is a fixed number of percentage points the lender adds to the index. It is set in your loan agreement.
The index plus the margin is often called the fully indexed rate. At each adjustment, your new rate is generally the index plus the margin, subject to any caps. When comparing ARMs, the Consumer Handbook on Adjustable-Rate Mortgages recommends looking at both the index and the margin for each offer.
Hybrid ARMs: what "5/1" means
Many ARMs are "hybrid" loans with a fixed-rate period followed by an adjustable period. The handbook explains that in names like 3/1, 5/1, 7/1, or 10/1, the first number is how many years the rate stays fixed. The second number is how often the rate can adjust after that. With a 5/1 ARM, the rate is fixed for five years and can then adjust once a year. Some ARMs adjust more often, such as every six months. Always check the adjustment schedule in the loan documents rather than relying on the name.
Rate caps and other ARM limits
Caps limit how much an ARM's rate can change. The handbook describes:
- Periodic adjustment caps, which limit how much the rate can change from one adjustment period to the next. Some ARMs allow a larger change at the first adjustment than at later ones.
- Lifetime caps, which limit how much the rate can rise over the life of the loan. The handbook notes that, by law, virtually all ARMs must have a lifetime cap.
Caps limit the size of an increase, but they don't prevent one. The handbook also describes carryover: on some loans, an increase that a cap blocked at one adjustment can be applied at a later one. That means your rate could rise even if the index has stayed the same.
Some ARMs have payment caps rather than rate caps, and some are interest-only for a period. With a payment cap, interest you don't pay may be added to your balance, which is called negative amortization. With an interest-only period, the payment rises once principal repayment begins, even if rates stay the same. Read our guide to mortgage amortization for more on how balances change.
A hypothetical payment comparison
To see how the trade-off works, compare two hypothetical $300,000, 30-year loans. The rates are illustrative only and are not current market rates.
Example: 30-year fixed vs. 5/1 ARM
- Fixed-rate loan at a hypothetical 6.5%: $1,896.20 per month in principal and interest for all 30 years.
- 5/1 ARM at a hypothetical 5.75% for the first five years: $1,750.72 per month for the first 60 payments.
The ARM's payment is $145.49 lower each month, about $8,729 less over the five-year fixed period. After 60 payments, the ARM balance would be about $278,286, compared with about $280,833 on the fixed loan.
In year six, the ARM payment is recalculated on the remaining balance over the remaining 25 years at the new rate:
| New rate in year 6 | New monthly payment | Change from the initial $1,750.72 |
|---|---|---|
| 4.75% (rate falls 1 point) | $1,586.56 | −$164.16 |
| 5.75% (no change) | $1,750.72 | $0.00 |
| 6.75% (rate rises 1 point) | $1,922.71 | +$171.99 |
| 7.75% (rate rises 2 points) | $2,101.98 | +$351.26 |
If the rate rose two points at the first adjustment, the ARM payment would be about $206 higher than the fixed-rate payment, and later adjustments could raise it further, up to the lifetime cap. This example shows only one adjustment. A real ARM would follow its own index, margin, caps, and schedule.
To run scenarios like this with your own numbers, use the mortgage payment calculator at the starting rate and at a higher rate. The math behind each payment is explained in how mortgage payments are calculated.
Side-by-side comparison
| Feature | Fixed-rate | Adjustable-rate (ARM) |
|---|---|---|
| Interest rate | Set at closing; doesn't change | Can change after the initial period, based on index plus margin, subject to caps |
| Principal-and-interest payment | Same for the life of the loan | Can rise or fall at each adjustment |
| Starting rate | Often higher than an ARM's introductory rate | Often lower at first |
| Main risk | Paying more if rates fall and you don't or can't refinance | Payment increases ("payment shock") if rates rise |
| Budget planning | Simpler and more predictable | Requires planning for possible higher payments |
Questions to ask before choosing
The CFPB suggests understanding these points before you take an ARM:
- How high and how low could the rate and payment go at each adjustment?
- How often does the rate adjust, and when could the first increase happen?
- What caps apply, and what is the highest rate the loan could ever reach?
- Could you afford the payment at the maximum rate allowed?
Also consider:
- How long you expect to keep the loan. An ARM's lower starting payment may appeal if you are confident you will sell before the first adjustment. But the CFPB warns against assuming you'll be able to sell or refinance before the rate changes, because home values and your finances can change.
- Your margin for error. If a payment increase like the one in the example would strain your budget, the predictability of a fixed rate may be worth more than the initial savings. Lenders also assess your debt-to-income ratio, and the handbook notes that lenders generally must consider your ability to repay based on the fully indexed rate or the highest rate in the first five years.
- Refinancing costs. Refinancing involves closing costs, and there is no guarantee you'll qualify later. Our refinance break-even calculator shows how long it takes for savings to cover those costs.
- Prepayment penalties. Check whether either loan charges a fee for paying off early, which could make refinancing or selling more expensive.
Your lender must give you a Loan Estimate within three business days of receiving your application. Because every lender uses the same standard form, you can compare fixed-rate and adjustable-rate offers side by side, including how an ARM's payment could change.
Key takeaways
- A fixed-rate mortgage keeps the same principal-and-interest payment for the life of the loan.
- An ARM usually starts lower, then adjusts based on an index plus a margin, within caps.
- In a hybrid ARM like a 5/1, the first number is the fixed period in years and the second is how often the rate adjusts after that.
- Caps limit increases but don't prevent them. Make sure you could afford the highest payment the loan allows.
- Don't count on selling or refinancing before an ARM adjusts.
Compare a fixed-rate payment with an ARM's starting and adjusted payments using your own loan amount.
Open the mortgage payment calculatorSee how the balance falls under each option with the mortgage amortization calculator, or browse all mortgage calculators.
Sources
- What is the difference between a fixed-rate and adjustable-rate mortgage (ARM) loan? — Consumer Financial Protection Bureau
- Consumer Handbook on Adjustable-Rate Mortgages (PDF) — Consumer Financial Protection Bureau (originally prepared by the Federal Reserve Board and the Office of Thrift Supervision)
- What is a prepayment penalty? — Consumer Financial Protection Bureau
- What is a Loan Estimate? — Consumer Financial Protection Bureau
- Loan Estimate explainer — Consumer Financial Protection Bureau
This article is for general educational purposes only and is not financial, legal, or tax advice. ClearPath Guides is not a lender, mortgage broker, or licensed adviser. Rates shown are hypothetical and are not offers or forecasts. Read our full disclaimer.
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