ARM vs. Fixed Rate Mortgages

When researching and shopping for a mortgage, one major factor is the interest rate of the loan. The interest is basically the percentage of the borrowed money you must pay each year on the outstanding balance in return for the bank allowing you to borrow the money. There are two types of mortgages: a fixed rate mortgage and an adjustable rate mortgage. Being a knowledgeable consumer will allow you to save money in the long run.

A fixed rate mortgage is one that comes with an interest rate that will remain the same throughout the life of the loan. This type of loan allows the homeowner to rest comfortably, knowing that their monthly payment will remain the same, regardless of any fluctuations in the economy that cause interest rates to rise. These mortgages are simple to understand. Also, with interest rates at historic lows, using a fixed rate mortgage to lock-in a rate ensures that you will have an “inflation hedge” since your house value may rise with inflation but your fixed payment does not. An online calculator can help you estimate the monthly payment.

An adjustable rate mortgage, otherwise known as an ARM, is a mortgage whose interest rate fluctuates based on the economy. Typically, ARMs are cheaper in the beginning, allowing people to purchase more expensive homes than they could with a fixed rate mortgage. But these mortgages adjust with interest rates, so your payment could rise or fall with interest rates. ARM mortgages are also difficult to understand and their terms are often confusing to an average homebuyer.

 Why might you choose an ARM despite the risks? If you’re only planning on staying in a home for less than five years, then an ARM would make sense because the first few years of the payment are less expensive. Plus, a short term stay in a home would mean that you would probably be moving before the interest rate adjusts. However, it’s important to calculate what your payment would be if interest rates rise sharply. Would you still be able to afford the payment with a significant increase? If you answered “no” to either question, then go with a fixed rate.

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.