Fixed vs. adjustable-rate mortgage: Which one actually serves your financial future?

While a fixed-rate mortgage has the same interest rate throughout the loan, the rate for an adjustable-rate mortgage (ARM) changes after an introductory period. For the right borrower, an ARM can mean significant savings, as the initial monthly payments can be considerably lower. However, the rate can also go up, increasing the monthly payment. Knowing your income trajectory, long-term goals and other planned financial events can help you determine whether an adjustable or fixed rate is right for your household.

Buying a home and securing a mortgage is one of the biggest financial decisions you'll ever make. While a lot goes into getting and repaying a mortgage, many people have been conditioned to focus on just one factor: the interest rate.

But there's more to choosing a mortgage than just the rate. A mortgage is a vital financial instrument that's part of your household balance sheet. It's essential to understand how your mortgage will help you achieve your other financial goals, and which options make the most sense for you today and in the future.

Learn how fixed-rate vs. adjustable-rate (ARM) mortgages work and how to decide which one fits into your overall financial picture, during the first year of repayment and beyond.

How a fixed-rate mortgage works

Whether you choose a 15- or 30-year mortgage, the interest rate on a fixed-rate loan is the same from day one until the day you make your final payment. That means your principal and interest payment will remain the same throughout your payment term, while your insurance and property taxes may go up or down.

With fixed-rate mortgages, the shorter the loan term, the lower the interest rate. While 15- or 30-year loans are standard, other options, like 10- or 20-year loans, are also available. With shorter loan terms, you pay less overall but have higher monthly payments.

When interest rates are higher, it may be tougher to qualify for a fixed-rate loan, since that higher interest rate payment is permanent. In any case, a lender looks at your income, credit history and current debt when deciding whether you qualify for the loan and what interest rate to offer you.

Pros of a fixed-rate mortgage

A fixed-rate mortgage gives you a degree of certainty in an uncertain world. Benefits of this type of mortgage include:

• Consistent payment amount: You'll have the same principal and interest payment throughout the loan term, with no adjustment surprises.
• Reduced rate risk: Your rate is unaffected even if market rates increase after closing.
• Simplified long-term planning: Predictable monthly payments simplify your household cash flow management over many years.

If you plan on staying in your home for at least 10 years and you have a relatively stable income, a fixed-rate mortgage may be the best fit for you.

Cons of a fixed-rate mortgage

Fixed-rate mortgages aren't without their drawbacks, such as:

• Higher initial rate: You'll likely have a higher interest rate with a fixed-rate loan compared to the rate offered during the introductory period for an ARM.
• Can't tap into lower rates: If market rates drop, you can't take advantage of them unless you refinance your mortgage, which brings additional qualification requirements and costs.
• It's not the right instrument for every household: If your income is likely to increase, you plan on selling after a few years or have other financial plans on the horizon, you may end up paying a premium for a certainty you don't need.

How an adjustable-rate mortgage works

An adjustable-rate mortgage has a fixed rate for an initial period, often five, seven or 10 years. After that, the rate adjusts periodically based on the market. ARMs are notated with two numbers, such as "7/6 ARM" or "10/6 ARM." The first number refers to the number of years the rate is fixed, so either seven or 10 years in the two examples. The second number refers to how often the rate adjusts after the introductory period, so every six months in the two examples listed.

Three factors affect how the rate adjusts. The first is the index rate, usually the Secured Overnight Financing Rate (SOFR), which fluctuates with the broader economy. After the initial fixed period, the ARM rate is tied to the index whenever it adjusts.

The next factor is the margin, or a fixed percentage the lender adds to the index. The margin rate is set at the loan's origin and doesn't change. It typically ranges from 2% to 3.5%.

Finally, the rate cap limits how much the rate can increase. There are three types:

• Initial: Maximum amount the rate can increase or decrease when it first adjusts
• Periodic: Maximum increase or decrease with each adjustment
• Lifetime: The most the rate can adjust over the life of the mortgage

For example, an ARM may have an initial rate cap of 2%, meaning the rate can't be more than 2% above or below the introductory rate. With a periodic rate cap of 1%, the rate can't change by more than 1% at each adjustment. A lifetime rate cap of 5% means there can't be more than 5% higher or lower than the initial rate at any point.

Pros of an adjustable-rate mortgage

An ARM has several benefits for the right borrower:

• Lower initial rate: The introductory rate is often lower than a fixed-rate mortgage, with the potential for significantly lower monthly payments at the outset.
• Access to lower rates: If market rates drop after the fixed period, the ARM rate and monthly payment are likely to decrease as well.
• Efficient instrument for the right buyer: If you plan on selling, refinancing or paying off the loan before the end of the introductory period, you can capture real savings with minimal rate risk.
• Improved qualification power: Those lower early payments can mean you qualify for a larger loan and reduce early cash flow pressure.

Cons of an adjustable-rate mortgage

ARMs aren't without their potential drawbacks:

• Rate risk after the fixed period: If market rates have risen, your monthly payments can increase significantly when the rate adjusts, even with caps in place.
• Planning complexity: It's harder to forecast monthly payments beyond the fixed period, which makes long-term household budgeting more complicated.
• You need to know the worst-case scenario: Before borrowing, calculate the maximum potential principal and interest payment, based on the lifetime cap. If you can't absorb that payment amount, an ARM isn't for you, regardless of the introductory savings.
• Refinancing may not be an option: If your plan is to minimize adjustment risk by refinancing, know that it may not be an option, especially if your income, your credit or the market changes.

How to choose: The decision framework

So, how do you decide if a fixed-rate vs. ARM mortgage is the best fit for your household and financial future? Answering a few questions can help guide you:

How long do you plan to stay in the home?

If you're looking to move within seven years, the ARM fixed period may cover your entire ownership window, meaning the rate savings are real.

Can your household budget absorb the worst-case ARM payment? If your monthly payment reaches the lifetime cap, could you pay it?

If you can't feasibly cover the highest possible ARM payment, choosing an ARM is a gamble, not a risk-management tool.

What's your income trajectory?

If you're expecting your income to increase over the next five to seven years, you'll have more capacity to absorb a higher ARM adjustment. But if you're expecting your income to stay flat or even drop, you won't.

Is a big payoff or liquidity event coming your way? Or do you plan to downsize once the kids leave home?

If you're anticipating a big payout or plan to downsize to a less expensive home in the next few years, the ARM's cost efficiency may align perfectly with your exit timeline.

What does your overall financial picture look like, beyond your mortgage payment? Do you have a significant amount of savings, little or no other debt and strong equity?

If you have a strong financial foundation with low debt and a strong savings profile, you can likely absorb the risk associated with an ARM better than a household that's stretched thin.

Aligning your home loan with your life

All in all, when deciding between an ARM or fixed-rate loan, you want to look beyond which rates are lower today. Instead, evaluate your current and future financial picture and focus on the loan structure that will serve your household's financial life for the duration of the mortgage. Is a fixed-rate home loan the best fit for you? Check out Citizens mortgage loan rates and options.