This calculator helps home buyers compare the monthly payments on fixed-rate home loans, interest-only (IO) payments & fully amortizing adjustable-rate mortgages.
In addition to estimating monthly principal & interest payments this calculator also helps buyers estimate the other monthly fees associated with home ownership including property taxes, insurance, along with any association dues. After calculating results users can also create side-by-side printer-friendly amortization schedules.
We publish current Cambridge mortgage rates in an interactive table which allows you to compare and contrast monthly payments and interest rates for fixed & ARM loan options.
ARM vs Fixed Rate Mortgage Calculator
Current Cambridge 30-YR Fixed Mortgage Rates
The following table highlights current Cambridge mortgage rates. By default 30-year purchase loans are displayed. Clicking on the refinance button switches loans to refinance. Other loan adjustment options including price, down payment, home location, credit score, term & ARM options are available for selection in the filters area at the top of the table.
Comparing Adjustable-rate Loans with Fixed-rate Mortgages
Homebuying is a process that requires careful financial planning. Besides building your income and credit score, you must choose the right type of loan. This involves comparing different mortgage lenders to find the best rate at the most favorable term.
One of the first things you must decide on is your loan’s payment structure, which comes in two main types: fixed-rate mortgages (FRM) and adjustable-rate mortgages (ARM). FRMs offer the advantage of predictable monthly payments, while ARMs have rates that change periodically based on benchmark index rates. Borrowers who choose ARMs also have the option to make interest-only (IO) payments, allowing affordable monthly payments for a limited period of time.
Our article will compare the differences between ARM and fixed-rate mortgages. We’ll explain their advantages and drawbacks, as well as when it’s a good idea to take each type of loan. We’ll also discuss how ARM interest-only payments work, and how this option can benefit borrowers. By understanding your mortgage options, we hope you can make sound financial choices before closing a mortgage deal.
Adjustable-rate Mortgages vs. Fixed-rate Loans
Fixed-rate mortgages (FRM) are the most commonly purchased mortgage product in the U.S. This preference indicates consumers value the stability of long-term fixed payments. As its name implies, FRMs come with a fixed annual percentage rate (APR) for the entire life of the loan. This results in the same monthly principal and interest payments (P&I) even if current market rates increase.
The predictable payments guarantee your mortgage payments remain within an affordable range. Though your property taxes, mortgage insurance, or homeowner’s association fees may increase, your principal and interest payments are locked. FRMs are usually taken as 30-year fixed mortgages, while 15-year fixed terms are popular among borrowers who want a shorter term.
In contrast, adjustable-rate mortgages (ARM) have changing interest rates that reset periodically. It comes with a 30-year term and is usually taken as a hybrid adjustable loan with a fixed introductory rate. Common hybrid terms are 5/1, 7/1, and 10/1 ARMs. For instance, if you take a 5/1 ARM, your rate stays locked for the first 5 years of the mortgage. After this initial period, the rate adjusts once a year for the rest of the term.
Once market rates increase, borrowers must prepare for higher monthly payments. For this reason, ARMs are not a popular loan option for most borrowers. Meanwhile, if rates reset low, borrowers will benefit from affordable monthly payments. ARMs typically come with a lower introductory rate than FRMs in a rising interest rate environment. It’s a viable option for consumers who plan to stay for a few years in a house.
When you take an ARM, lenders may provide the option to make interest-only payments (IO). Making IO payments allows borrowers to delay principal payments during the introductory period of the loan. It only requires you to cover interest charges, at least during the first couple of years of the mortgage. This results in cheaper and more manageable monthly payments. Once the initial period ends, your loan will start to amortize. You must then pay regular principal and interest payments for the rest of the remaining term.
Low Rates & Mortgage Product Market Shares
The COVID-19 crisis prompted the Federal Reserve to keep benchmark rates near zero in 2020, resulting in record low mortgage rates. With market rates falling, more consumers were driven to obtain fixed-rates loans, which had lower rates than the ARM’s introductory rate. According to the Urban Institute, 30-year fixed mortgages comprised 74.7% of new loan originations in November 2020, while 16.1% accounted for 15-year fixed mortgages, which were mostly refinances. On the other hand, ARMs only took 0.7% of the market share. In a low-interest rate environment, more consumers tend to secure fixed-rate mortgages with lower rates.
The Fundamentals of Fixed-rate Mortgages
Fixed-rate mortgages (FRM) are ideal for homebuyers looking for a permanent or long-term home. It’s the default option for homebuyers who want the security of predictable payments throughout their mortgage. Unchanging monthly principal and interest (P&I) payments are a lot easier to budget. This way, you can plan your finances without worrying about higher payments even if market rates rise.
Borrowers who obtain fixed mortgages typically have good credit scores and a steady source of income. These are consumers who have reached a level of stability, who can likewise afford fixed mortgages at market rates. On the other hand, borrowers who intend to stay short-term in a house typically opt for ARMs. They take advantage of the low introductory rate and sell the house, ideally before the rate adjusts.
In the U.S., 30-year fixed mortgages are the most popular loan option for borrowers. This is the go-to option for buyers especially if it’s their first home purchase. The extended term comes with more affordable monthly payments in contrast to shorter terms. It also allows borrowers to obtain a larger loan amount compared to shorter loans such as 15-year fixed terms. Fixed-rate mortgages are also available in 20-year and 10-year terms.
But as a trade-off for predictable payments, expect fixed-rate loans to come with higher rates, more specifically for longer terms. Over time, the dollar value decreases due to inflation. This results in less profit for lenders. To hedge against duration risk and inflation, lenders assign much higher rates to extended fixed-rate loans. Thus, the longer you pay your loan, the more interest the lender charges.
The following chart shows FRMs and their corresponding APRs as of February 14, 2021:
| Fixed-rate Mortgage | Rate (APR) |
|---|---|
| 30-year FRM | 3.16% |
| 20-year FRM | 3.07% |
| 15-year FRM | 2.67% |
| 10-year FRM | 2.54% |
Based on the chart, the 30-year FRM has the highest APR at 3.16%, while the 10-year FRM has the lowest APR at 2.54%. The 15-year FRM is at 2.67% APR, which is lower by 0.49% than the 30-year FRM. 30-year FRM rates are generally higher by 0.25% to 0.50% than 15-year FRM rates.
To give you an idea how long terms impact mortgage payments, let’s review this example. Suppose you’re purchasing a house valued at $320,000 and you’ve made a 20% down payment worth $64,000. This reduces your loan amount to $256,000. If you take a 30-year FRM or a 15-year FRM, the following chart shows monthly principal and interest (P&I) payments together with total interest costs.
House price: $320,000
Down payment: $64,000
Loan amount: $256,000
| Mortgage Term | 30-year FRM | 15-year FRM |
|---|---|---|
| Rate (APR) | 3.16% | 2.67% |
| Monthly P&I payment | $1,101.52 | $1,727.54 |
| Total interest costs | $140,548.00 | $54,957.68 |
According to the chart, your monthly P&I payment will be $1,101.52 if you take a 30-year FRM. This is a lot cheaper by $626.02 compared to taking a 15-year FRM with a $1,727.54 monthly payment. And for many consumers, a lower monthly payment is the more practical option. However, when we compare the total interest charges, the 30-year FRM costs $140,548 in interest charges, while the 15-year FRM only costs $54,957.68. In this example, a 15-year FRM will save you $85,590.32 over the life of the loan. If you can afford the higher monthly payments, the 15-year FRM will yield more substantial savings.
Whether you save money on an FRM will depend on how market rates change over the years. If it rises above the mortgage rate you originally signed, an FRM will likely save you more money. However, if you got a high rate and general market rates considerably fall, your mortgage would end up costing more. Thus, when there’s a substantial decrease in market rates, many homeowners tend to refinance their mortgage.
Due to historic low rates caused by the COVID-19 crisis, a refinancing boom spurred in 2020. Mortgage refinances increased up to 200% in September 2020 compared to 2019. Many homeowners refinanced their loan to take advantage of the record low rates. This is a favorable option especially for people who plan to stay for good in a home.
Mortgage Refinancing
Refinancing is a financial strategy that allows borrowers to change their current mortgage with a more favorable rate and term. It’s essentially taking a new loan to pay off your existing debt. Mortgage refinancing enables borrowers to reduce their interest rate, shorten their payment term, or both. This results in considerable mortgage savings compared to remaining with their original mortgage. Many borrowers eventually refinance from an ARM to an FRM to lock in a low fixed rate. This allows them to avoid increasing payments when general market rates rise.
However, note that refinancing comes with expensive costs. The closing costs typically run between 3% to 6% of your loan amount. You must also have a credit score of 620 to qualify, but it’s ideal to have a higher credit score of 700 and above to secure a lower rate. Moreover, refinancing too early may incur prepayment penalty charges, which is usually around 1% to 2% of your loan. To justify refinancing, your new rate must be 1% to 2% lower than your original rate. This allows you to recoup the closing costs of refinancing sooner.
Obtaining mortgage approval for an FRM is more challenging for borrowers. Those with limited income and poor credit scores can’t just take an FRM. That said, it’s a lot easier for borrowers to qualify for an adjustable-rate mortgage (ARM). ARMs are a type of subprime mortgage which come with more lenient credit standards. The changing rates mean lenders can profit from borrowers when rates increase throughout the term. Thus, it pays to obtain a loan with stable mortgage payments.
In other cases, you might secure an FRM with a higher rate. Despite the stable payments, this results in expensive monthly payments and total interest charges. When this happens, the only way to reduce your mortgage expenses is to refinance into a lower rate.
To weigh in on the benefits and disadvantages of FRMs, refer to the chart below:
| Pros | Cons |
|---|---|
| Rate stays locked for the entire term. | Qualifying for an FRM is more difficult than an ARM. |
| Monthly P&I payments remain the same, even if property taxes or HOA fees increase. | Comes with a higher rate than an ARM during a rising interest-rate environment. |
| Unchanging payments are easier to budget. | You keep paying the same rate even if market rates fall. |
| No sudden increases that cause payment shock. | The only way to reduce your rate is to refinance your loan. |
| You’ll build substantial equity right away. | Costly and not favorable for people who will move in a few years. |
Understanding How ARMs Work
Borrowers who choose adjustable-rate mortgages (ARM) take advantage of the affordable introductory rate. In a growing economic environment, ARMs typically have a lower rate than fixed-rate loans. This is a practical option if you plan on moving in a few years. The low rate allows you to make cheaper mortgage payments, which is favorable if you’re not staying in a home for good.
ARMs are a good fit for borrowers who don’t intend to live long-term in a property, or for those looking for a starter home. It’s also for people who have careers that require them to move every couple of years. In other cases, people with expensive mortgages such as jumbo loans also take advantage of ARMs for the low introductory rate.
ARM borrowers try to sell their house before the introductory period ends. This lets them steer clear of expensive mortgage payments when rates increase. Professional house flippers also use ARMs when they purchase old property. They are known to renovate cheap homes and sell them for a higher mark up, typically within a 12-month period.
ARM rates adjust periodically and come with a 30-year term. Borrowers can obtain straight ARM loans with rates that reset every once year. These days, hybrid adjustable mortgages are more common in the market. These are usually available in 5/1, 7/1 and 10/1 ARM terms. For example, if you take a 5/1 ARM, your rate remains fixed during the first 5 years of the loan. After this introductory period, your rate resets once every year for the rest of the term. The most popular hybrid ARM taken by consumers is the 5/1 ARM.
As of February 14, 2021, the following chart shows corresponding rates for different ARM terms:
| ARM | Rate (APR) |
|---|---|
| 5/1 ARM | 3.99% |
| 7/1 ARM | 3.86% |
| 10/1 ARM | 3.9% |
While fixed rates are typically higher with longer terms, in this example, the 5/1 ARM has the highest rate. Since 5/1 ARMs are more common among borrowers, lenders tend to offer the highest rate on this ARM term. In a rising interest rate environment, ARMs typically have a lower introductory rate than a 30-year fixed-rate mortgage.
ARMs are a type of subprime loan. If you have limited income and low credit, it’s easier to qualify for a mortgage with an ARM than a fixed-rate loan. Some borrowers may use it as an entry point to afford a house. You may take an ARM and benefit from the low initial monthly payments. Before the introductory period ends, you should refinance into a fixed-rate mortgage to lock in a low rate. This ensures you won’t deal with higher monthly payments in the future.
That said, ARMs are generally a risky proposition. You must prepare for increasing mortgage payments which may become unaffordable in the long-term. If you are unable to sell your home or refinance into a fixed-rate loan, be ready for expensive monthly payments. Trouble making payments might put your home at risk of foreclosure. On the other hand, if rates reset lower, you have the benefit of making affordable payments. But note that rates don’t stay low forever. Because rates rise in a growing economy, many ARM borrowers eventually refinance into an FRM to secure stable monthly payments.
To assess the advantages and drawbacks of ARMs side by side, refer to the chart below:
| Pros | Cons |
|---|---|
| It's easier to qualify for compared to an ARM. Accessible to borrowers with low credit scores. | Mortgage rate changes periodically. May increase or decrease after the introductory period. |
| Usually comes with a lower initial rate than an FRM during a rising interest rate environment. | It’s harder to plan your budget when rates and payments change. |
| The low initial rate provides affordable monthly P&I payments. | The rate eventually rises, resulting in higher monthly P&I payments. May cause payment shock. |
| The low introductory rate can allow you to qualify for a larger loan amount. | Rising interest rates can make your payment too expensive. |
| If market rates fall, you can take advantage of affordable monthly payments. | Trouble with monthly payments puts your home at risk of foreclosure. |
Interest-Only Payments on Mortgages
Borrowers who take adjustable-rate mortgages have the option to take interest-only payments (IO). This allows you to defer principal payments on your loan for a set period of time. With interest-only payments, you may only elect to cover interest payments during the introductory period of the ARM. Depending on your ARM term, this can last for 5, 7, or up to 10 years. Taking this option let’s you make cheaper mortgage payments during the first few years of the loan. After the interest-only period, you must make regular principal and interest payments.
Interest-only payments are a viable option for borrowers who want affordable initial payments. These are a good fit for people who expect to increase their income over time to afford the full monthly mortgage payments. It’s also a good option if you plan to sell your property in a couple of years. Some people may elect to make extra payments on their mortgage to reduce their principal faster. However, early extra payments may require prepayment penalty charges, so ask about this before making extra principal payments. The interest-only period allows borrowers to save and build funds before the loan starts regular amortization.
For example, if you take a 5/1 ARM, you are only required to make monthly interest payments on your mortgage for the first 7 years of the loan. It’s up to you if you want to pay toward your principal. With this setup, you effectively make your monthly payments more affordable, at least for the first several years. After the interest-only period, your rate adjusts, and your loan amortizes for the remaining term. At this point, you must make full principal and interest payments each month until your mortgage is paid off.
If you intend to sell your home before the interest-only period ends, you can make a large payment called a balloon payment. Typically, this is done by taking proceeds from the home’s sale to cover the remaining principal and interest balance on your mortgage. Borrowers usually do this if they plan to move after a few years. The balloon payment strategy is also used by home flippers to cover mortgage on properties they buy, renovate, and sell.
On the other hand, taking an interest-only mortgage spells bad news for your home equity. Because you’re deferring principal payments, you won’t build as much home equity on your loan. In contrast to fixed-rate mortgages, you immediately gain home equity because you pay a portion of your principal each month. If your goal is to build home equity as soon as you can, taking an interest-only option is not a good idea.
Moreover, deferring principal payments does not guarantee you can save enough to cover your mortgage. If you fail to cover interest payments, you run the risk of negative amortization. Emergency expenses, including other discretionary costs, can take up your savings. And once the loan amortizes and your rate increases, you must deal with payment shock. The significant increase in monthly payments may give you a hard time adjusting to higher expenses. And if rates continue to increase, you’ll have trouble making payments, which puts your home at risk of foreclosure.
Negative Amortization
Besides interest-only payments, some ARM lenders allow you to cover only a portion of the interest payment each month. This is a risky proposition, which results in negative amortization. When negative amortization occurs, your unpaid interest is carried over to your principal balance. Instead of gradually diminishing your principal, this unfortunately increases the amount you borrowed.
With negative amortization, you can end up owing more on your mortgage than your property’s value. If you take this option, you run the risk of foreclosure if you fail to keep up with monthly payments. Even if you sell your home, the home’s price will not be enough to pay for your mortgage. It’s best to steer clear of negative amortization at all costs.
To summarize the benefits and disadvantages of taking an interest-only option, refer to this chart:
| Pros | Cons |
|---|---|
| You only need to make interest payments during the first few years of the loan (interest-only period). | Deferring principal payments mean you do not build home equity right away. |
| Your monthly mortgage payments will be cheaper. | While you have time to save, you may also be tempted to spend for other costs. |
| The low monthly payments allow you to qualify for a larger loan amount. | After the interest-only period, your monthly payments will increase significantly. |
| The low monthly payments may allow you to prepay your mortgage. | If you make extra payments toward the principal, you might be charged prepayment penalty fees. |
| During the interest-only period, you can save and invest money in other worthwhile ventures. | If market rates continue to increase, your payments will become unaffordable. |
| Monthly payments for the interest-only period qualifies as tax deductible. | If you have trouble meeting expensive payments, it puts your home at risk of foreclosure. |
How Adjustable Rates are Determined
Many factors influence how rates change and impact adjustable-rate mortgage (ARM) payments. Before you choose this type of loan, learn about the different variables that affect the cost of ARMs:
Margin
An adjustable-rate loan is calculated by using a margin, which is a fixed percentage. When you take an ARM, you commit to pay a higher percentage than the referenced index rate. When added to the index rate, this determines the fully indexed rate of your mortgage. An indexed rate refers to the lowest rate your ARM lender can offer, while the fully indexed rate is the margin added to the benchmark rate. To determine your ARM’s interest rate, follow this formula:
ARM Interest Rate = Index + Margin
Depending on your lender, a margin may come in incremental values, such as 0.375%, 1.25%, and so on. Borrowers with high credit scores are usually offered a lower margin. The low margin results in a lower interest rate for your loan, which yields greater interest savings. On the other hand, ARM borrowers with lower credit scores typically receive higher margins, which results in higher mortgage rates.
The margin is an important calculation which varies between lenders. This number helps determine the true cost of your ARM. Obtaining a lower margin is also generally more favorable for borrowers. Though the margin will not usually change in an ARM, the benchmark index rate certainly will.
Benchmark Index Rates
Benchmark index rates generally reflect market performance. Lenders refer to many types of benchmark indexes to calculate mortgage rates. In global credit markets, interest rates fluctuate daily. While there may be a movement of only a fraction of a percentage, the ripple effect it can have is enormous because many types of loans are directly influenced by these benchmarks.
The term benchmark describes indexes adopted and approved by multiple loan providers as a standard. A benchmark index will have millions of dollars in ancillary products built off its stability and dependability. A benchmark index rate fluctuates based on shifts in the buying public and market conditions.
A borrower cannot do much about the effects of a specific benchmark, but they can arm themselves with knowledge. It helps to know different benchmark indexes commonly used in mortgage deals, how they compute their baseline, and how they factor into the final APR.
The following are commonly used indexes by lenders:
- LIBOR: The London Inter-Bank Offered Rate (or ICE LIBOR, for Intercontinental Exchange LIBOR) has been the primary benchmark for short-term interest rates around the world. This rate is based on the average interest a collection of London-based banks would charge to other banks for a loan. It is published daily and drives billions of dollars in global derivatives that rely on it to set their own variable rates. LIBOR rates are calculated daily for seven borrowing periods ranging from overnight to one year. They are also applicable in five worldwide currencies. LIBOR rates are sometimes estimated rather than being calculated from the data of transactional histories. Though LIBOR is has been widely used by lending institutions worldwide, the Consumer Financial Protection Bureau (CFPB) reported that LIBOR will be phased out some time after 2021. Over the years, CFPB’s report noted that transactions based on LIBOR don’t occur a frequent as they did in the past. This makes LIBOR a less reliable benchmarks for banks. To take its place, the Alternative Reference Rates Committee (ARRC) recommended the use of SOFR.
- SOFR: A recent addition to the pool of benchmarked reference rates (April 2018), SOFR or Secured Overnight Financing Rate, is a U.S.-based answer to dependence on LIBOR. SOFR is based on the average amount of interest charged by New York banks for cash borrowed overnight. It is also secured by Treasury Securities. Because SOFR is based on actual transactional activity being measured daily, not using estimates as LIBOR does, it is felt to be more transparent and perhaps more secure from manipulation. Results are published daily.
- COFI: COFI stands for the 11th District Monthly Weighted Average Cost of Funds Index, which reflects the interest rate offered by average on checking and savings accounts for qualified accounts in California, Nevada, and Arizona. The results are calculated monthly, and each published result is for the previous month’s totals.
- CMT: The Constant Maturity Treasury index is based on yields from a range of Treasury securities adjusted to a constant maturity, like one or five years. Because the nature of this index is considered a risk-free security, lenders using this index will typically add a percentage to cover their own risks. A CMT rate of 4% might be presented to the buyer as 5% with the lender’s mark-up. This is also a legitimate index often used for deciding the variable rate for many short-term loans.
Other notable benchmark index rates include the following:
- Prime Rate – Bank Prime Loan
- COSI – Cost of Savings Index
- MTA or MAT – 12-Month Treasury Average
- T-Bill – Treasury Bill
- CODI – Certificate of Deposit Index
Though the lender’s margin is fixed, the referenced benchmark rate assigned on the ARM changes depending on market performance. Benchmark levels may fluctuate daily, but how frequently changes are applied to the APR is really what affects your loan’s costs.
For example, the LIBOR rate changes daily but a loan using that rate may only adjust itself annually, or bi-annually. The COFI rate adjusts only monthly. An ARM loan adjusted using a COFI baseline does not look at the daily history of the rate changes any more than a LIBOR-based loan would – it simply applies its adjusted rate as recorded at a specific date and time.
So the LIBOR rate could have shifted dramatically every day, while the COFI stayed steady week over week. However, if they end up at the same rate on the day it is recalculated, the borrower will still pay the same rate until it is once again recalculated.
What Index to Use? When interest rates are rising, it’s advantageous to have your mortgage indexed to a lagging benchmark rate like COFI. But when rates are falling, a leading index such as CMT can be more beneficial to borrowers. What a borrower might consider is the stability or volatility of a given benchmark rate over time. While it is not a guarantee of performance for the index as applied to their own loan, it can illustrate likely scenarios that will tend to occur over time.
Rate Adjustment Frequency
The number of times your ARM rate adjusts is referred to as rate adjustment frequency. This basically indicates the interval at which your rate resets after the introductory period ends. Generally, the more often your rate adjusts, the more expensive your interest costs over the life of the loan. ARM rates usually adjust once a year after the introductory phase, while it adjusts every year or every six months if you take a straight adjustable-rate mortgage.
Having a longer period in between rate adjustments is more advantageous for borrowers. This gives them more time to save and prepare for increasing monthly payments. It’s also the reason why hybrid ARMS with fixed introductory rates are common among ARM borrowers.
Rate Caps
A big caveat on ARMs is the increasing mortgage rate that can result in unaffordable payments. While ARM rates change based on prevailing benchmark indexes, there are rate caps that limit how high your rate can increase.
For instance, you might find two ARM lenders who start off with the same introductory rate. One lender has a low rate cap, while the other one has a higher rate cap. When benchmark rates significantly increase, the loan with the higher rate cap will have a higher rate. Meanwhile, the loan with a lower cap will have a lower rate. Generally, obtaining a lower rate cap will help you maintain lower mortgage payments for the rest of the term.
Be sure to clarify your rate cap with your lender. Knowing your rate cap allows you to estimate how much extra money you should save before your rate reaches the limit. Aim to secure a lower rate cap to keep your monthly payments affordable. There are also different types of rate caps which impact your mortgage payments.
Three Main Kinds of Rate Cap
- Initial adjustment cap – This cap restricts how high your rate can increase the first time it adjusts. It applies right after your ARM’s introductory period ends. The initial adjustment cap is commonly 2% to 5% higher than the initial ARM rate.
- Subsequent adjustment cap – This puts a limit to how high your rate can rise in the following adjustment periods. Subsequent adjustments caps are usually around 2% higher than the initial ARM rate.
- Lifetime adjustment cap – This is the maximum interest rate allowed throughout your ARM term. Lifetime adjustment caps are typically 5% higher than the initial rate. However, depending on your lender, your lifetime cap may be much higher.
Comparing Mortgage Payments: FRM, ARM, & Interest-Only ARM Loans
While it’s easier to estimate payments on a fixed-rate loan, estimating payments for ARMs can be more challenging. But to make things easier, you can use the above calculator to compare FRM payments with ARM payments and interest-only (IO) ARM payments. To understand how this works, let’s review the following example.
Presuming you bought a house worth $320,000 with 20% down at $64,000. This reduces your loan amount to $256,000. Let’s say you’re comparing costs for a 30-year FRM at 3.16% APR, and a 30-year 5/1 ARM at 3.99% APR. See the results below.
House price: $256,000
Down payment: $64,000
Loan amount: $256,000
30-year fixed interest rate: 3.16%
5/1 ARM introductory rate: 3.99%
ARM initial adjustment rate: 1.25%
ARM subsequent adjustment rate: 0.25%
ARM lifetime cap: 8%
Annual property taxes: $2,500
Annual homeowner’s insurance: $1,200
Monthly HOA fees: $100
| Loan Details | FRM | ARM | Interest-only ARM |
|---|---|---|---|
| Beginning monthly P&I payments | $1,101.52 | $1,220.71 | $851.20 |
| Monthly fees | $408.33 | $408.33 | $408.33 |
| Beginning monthly P&I with fees | $1,509.85 | $1,629.04 | $1,259.53 |
| Maximum monthly payment with fees | $1,509.85 | $2,116.82 | $2,115.00 |
| Total interest costs | $140,548.58 | $307,675.38 | $520,525.32 |
The results show that the FRM has a monthly P&I of $1,101.52, while the ARM has a beginning monthly P&I of $1,220.71. The FRM monthly P&I is cheaper by $191.19 than the initial ARM P&I payment. On the other hand, expect to have a low initial payment with an interest-only ARM, which costs $851.20 per month. You are only required to pay $851.20 per month for the first 5 years of the loan.
Meanwhile, the maximum monthly payment for the ARM will be $2,116.82. This is more expensive by $606.97 than the monthly payment for the FRM. Moreover, the maximum interest-only ARM payment is $2,115, which is higher by $605.15 than the FRM monthly payment. Since interest rates for ARMs can increase, you must set aside enough funds to cover higher payments in the future.
Next, the overall costs are more apparent when we compare interest charges. With an FRM, your total interest costs will amount to $140,548.58. But with the ARM, your total interest charges can be up to $307,675.38. Thus, if you choose the FRM, you can save up to $167,126.80 over the life of the loan. Meanwhile, if you choose the interest-only ARM, your total interest charges can be up to $520,525.32. That’s a lot higher than the amount you borrowed. Taking the FRM instead of the interest-only ARM will save you a total of $379,976.74. To avoid this exorbitant cost, you can eventually refinance from an interest-only ARM to an FRM with a lower rate.
The example above shows that it’s favorable to take an FRM when the rate is lower than an ARM. Also notice how interest-only loans tend to have expensive total interest charges. This is enough reason for interest-only ARM holders to eventually refinance into a fixed-rate loan.
In the next example, let’s compare mortgage payments between an ARM with a lower rate than an FRM. Given all factors are identical with the previous example, let’s suppose the FRM rate is 4% APR, while the ARM rate is 3.1% APR. See the results below.
House price: $256,000
Down payment: $64,000
Loan amount: $256,000
30-year fixed interest rate: 4%
5/1 ARM introductory rate: 3.1%
ARM initial adjustment rate: 1.25%
ARM subsequent adjustment rate: 0.25%
ARM lifetime cap: 8%
Annual property taxes: $2,500
Annual homeowner’s insurance: $1,200
Monthly HOA fees: $100
| Loan Details | FRM | ARM | Interest-only ARM |
|---|---|---|---|
| Beginning monthly P&I payments | $1,222.18 | $1,093.16 | $661.33 |
| Monthly fees | $408.33 | $408.33 | $408.33 |
| Beginning monthly P&I with fees | $1,630.51 | $1,501.49 | $1,069.66 |
| Maximum monthly payment with fees | $1,630.51 | $2,028.31 | $2,115.00 |
| Total interest costs | $183,986.95 | $263,735.27 | $478,720.40 |
In this example, if you take an ARM with a lower rate than an FRM, your beginning P&I payment will be $1,093.16. This is $129.02 more affordable than the monthly P&I on the FRM. The interest-only payment will also be much cheaper by $560.85 than the FRM. You’ll only be required to pay $661.33 per month to cover interest payments for the first 5 years of the loan.
On the other hand, the maximum monthly payment for the ARM will be $2,028.31. This is higher by $397.80 than the monthly FRM payment. Next, the maximum monthly payment for the interest-only ARM will be $2,115.00. This is more expensive by $484.49 than the FRM monthly payment. Be ready to cover higher mortgage payments when your rate increases.
Finally, the total costs are more evident when we compare the interest charges. With the FRM, your total interest costs will be $183,986.95. If you take the ARM, your total interest charges can be up to $263,735.27. If you take the FRM, you’ll save $79,748.32 compared to the ARM. Meanwhile, with an interest-only ARM, your interest costs can be as high as $478,720.40. This is more expensive by $294,733 than the FRM.
When taking an interest-only ARM, your initial monthly payments will be affordable. However, once the interest-only period ends, your loan amortizes, and your payments increase. It also increases further when your rate adjusts higher. If you take an interest-only ARM, be aware that the total interest cost can far exceed the original amount you borrowed.
This example shows it’s favorable to take an ARM if the interest rate is lower than an FRM. Your monthly payments will significantly affordable during the introductory period of the loan. If you plan to refinance or sell your home before the rate adjusts, this will save a lot on interest charges. However, if you’re unable to refinance before the rate increases, be sure you have enough funds to cover higher monthly payments. To avoid expensive payments when rates increase, it’s best to eventually refinance into a fixed-rate loan.
To recap the differences between ARMs and a fixed-rate mortgages, refer to the chart below:
| Loan Details | ARM | FRM |
|---|---|---|
| Type of Borrower | People who plan to move after a few years People who need a lower initial monthly payment to reach DTI requirements and refinance in the future People who believe rates are likely to decrease People who have high income and can handle market volatility House flippers who buy, renovate, & sell homes | People who prioritize stable & predictable monthly payments Can afford fully amortizing loans at market rates People with good credit scores and ample income People who think rates will likely increase People who want to settle long-term in a home People who are not investing in other high yield assets who can focus on making mortgage payments |
| Advantages | Typically comes with a low initial rate than fixed-rate loans during stable economic climate The low introductory rate lets borrowers pay affordable monthly payments during the first few years of the loan | Payments remain affordable even if market rates shift No need to worry about sudden increase in payments Borrowers can immediately build significant equity |
| Disadvantages | Monthly payments can adjust greatly after the introductory period Borrowers risk having unaffordable payments if they do not have enough funds | Charges a higher interest rate for stable payments Harder to qualify for compared to ARMs |
| Refinancing | While it locks your interest rate, you still have the option to refinance to a better rate and term Refinancing too early may come with prepayment penalty charges | You can refinance into a fixed-rate loan or ARM Some loans with market-low introductory rates may have prepayment penalty charges |
In Summary
Part of buying a home is deciding the type of mortgage that suits your needs. There are two main types of mortgages in the U.S. market, these are fixed-rate mortgages (FRM) and adjustable-rate mortgages (ARM). The most commonly purchased home loan is the 30-year fixed-rate loan, while ARMs only take a small portion of the housing market.
FRMs are more popular because they come with predictable monthly P&I payments. These are easier to budget than ARMs. It also guarantees your monthly payments remain affordable even if general market rates rise. On the downside, fixed-rate mortgages are harder to qualify for than ARMs. This option is suited for homebuyers looking for a long-term home, specifically those with stable incomes and high credit scores.
On the other hand, ARMs are characterized by rates that change periodically. These are commonly taken as hybrid ARM loans, such as 5/1 ARM terms. When you take this option, your rate remains fixed for the first 5 years. After this introductory period, your rate will change once a year for the rest of the term. ARMs are harder to budget because of the changing rates. When rates rise, you must prepare higher monthly payments. However, if rates reset low, you can also benefit from affordable monthly payments.
ARMs are advantageous when the rate is lower than a 30-year FRM. Borrowers who choose ARMs typically plan to move after a few years. People who intend to stay long-term in a home may also take an ARM. They can make use of the low introductory rate and eventually refinance into an FRM. Since rates do not stay low forever, many ARM borrowers eventually refinance into a fixed-rate loan.
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