Fixed rate versus adjustable rate - who wins?

Either a fixed-rate or adjustable-rate loan could be best for you. It depends on your plans and your risk tolerance.

With a fixed-rate loan, your monthly payment of principal and interest (P&I) never changes for the life of your loan. Your total monthly payment of principal, interest, taxes and insurance (PITI) will increase over time as property taxes and homeowner's insurance are increased, but generally with a fixed-rate loan your payment will be very stable and your taxes and insurance will rise regardless of the type of loan.

Fixed-rate loans are available for terms of up to 30 years. Fixed-rate loans are most conservative and you might choose a fixed-rate loan if you want to lock in a permanent interest rate and P&I payment. However, an Adjustable Rate Mortgage (ARM) may be a better option, since rarely does a borrower keep any loan, fixed or adjustable, until maturity and ARM loans usually offer much lower initial payments.

Adjustable-rate mortgage (ARM) loans, usually offer an initial interest rate well below fixed-rate loans. With an ARM loan, your monthly P&I varies over time as your interest rate adjusts, based upon an index plus a margin. A fully-indexed ARM is the current index, often the one-year Treasury Security, plus the margin for that ARM product. Most ARMs adjust once every year and most programs have "caps" that limit each adjustment. Typically, there is a cap on how much the interest rate can change at any one adjustment and a "lifetime cap".

ARMs often have their lowest, most attractive (or discounted) rates at the beginning of the loan, typically with an initial term from one to ten years. A 1 year ARM has an initial rate for 1 year and adjusts each year. A 3/1 ARM has a "fixed" rate for three years, and then adjusts every year thereafter for the life of the loan, and so on.

ARM loans are often best for people who anticipate lifestyle changes within a certain number of years, say three to ten. One might choose an ARM to take advantage of a lower introductory rate and plan on moving, refinancing or accepting the risk of a higher rate after the introductory rate period. With ARMs, you do risk your rate going up, but you also take advantage when rates go down.