The Right Rate: Fixed or Adjustable?

Not all simple questions have simple answers. If your grocer asks “paper or plastic,” you must pick convenience or environment. If your lender asks “fixed or adjustable,” you must choose stability or cost savings.

Fixed-rate mortgages (FRMs) have a permanent interest rate and monthly payment. The advantage here is that FRMs are predictable and, therefore, easy to budget over the long-term. Plus, when the fixed-rate mortgage is affordable, you realize increasing benefits over time. Assuming your income rises, you end up spending a smaller and smaller percentage of your income on housing—which leaves you with more cash to spend on other things.

Adjustable-rate mortgages (ARMs) are slightly more complicated. The interest rate is linked to an underlying index, such as the 1-year constant maturity Treasury index or CMT. In practice, this means the rate and the payment will fluctuate with changing economic conditions. As such, ARMs can be unpredictable. And the rate and payment can go down as well as up.  

Choosing the right mortgage rate

Three factors can help you decide between a fixed rate and its adjustable counterpart:

• Your plans for the future. The rate on an ARM is fixed for the first three, five, seven, or even 10 years of the loan. A 3/1 ARM, for example, has a fixed rate for the first three years, and is subject to annual rate changes thereafter. If you intend to sell the home or refinance the loan within that initial fixed period, you would not be exposed to any potential rate changes. Further, that initial rate may be lower than what you can get on a standard FRM. In this scenario, the ARM can save you money and keep your payment low. The risk is that your future plans change, interest rates rise, and you’re unable to sell or refinance.  


• The timing of your income. If you don’t earn income evenly throughout the year, a smaller ARM payment can help you manage through those lower income months. You can minimize your risk by making extra principal payments when your income is higher. This pays down your balance, thereby reducing the debt that’s subject to interest rate changes. Pay the balance down far enough and you’ll be able to refinance it into an affordable FRM. 


• Your appetite for risk. You may not feel comfortable with an ARM, even if it looks like the better deal on paper. Avoid the unnecessary anxiety and stay true to your risk tolerance. Life is too short to lose sleep over your mortgage.

Having mortgage smarts involves knowing the options, understanding your goals, and listening to your instincts. The choice between paper and plastic can be remade the next time you buy groceries—but you don’t have that luxury with your mortgage. Weigh your options carefully, and make your choice wisely.