Fixed vs. Adjustable-Rate Mortgage: What a 5/1 ARM Really Saves and Risks

How ARMs Work

An ARM is described by its structure, such as 5/1: the first number is the fixed period in years and the second is how often the rate adjusts after that, in years. After the fixed period, the new rate equals the index (such as the Secured Overnight Financing Rate, SOFR) plus the lender's margin, subject to caps. A typical cap structure like 2/2/5 means the rate can rise up to 2 percentage points at the first adjustment, up to 2 points at each later adjustment, and no more than 5 points above the starting rate over the life of the loan.

In our example, the worst case under 2/2/5 caps is 7.75% at the first reset, 9.75% a year later, and a lifetime maximum of 10.75%.

The Savings in the Fixed Period

During the first five years, the ARM payment is $1,867.43 versus $2,022.62. You save $155.19 a month. Because the rate is lower, more of each payment goes to principal: after 60 payments, the ARM balance is about $296,839 and the fixed-loan balance is about $299,555, a difference of $2,716 in your favor.

If you plan to sell or refinance before the reset, the ARM could clearly come out ahead. Many homeowners do move or refinance within 5 to 7 years.

The Reset Risk

At the first adjustment, the new payment is calculated on the remaining balance over the remaining 25 years. If the rate resets to 7.75%, the payment rises to $2,242.11, which is $374.68 above the initial payment and $219.49 above the fixed-rate payment. If it resets to 8.75%, the payment is $2,440.44. Over 10 years, the ARM would cost more than the fixed loan in these two scenarios ($246,573 and $258,473 versus $242,714), because the savings of $9,311 in the first five years are outweighed by higher payments afterward.

If rates fall, the ARM could reset lower than your starting rate, and the borrower benefits. But nobody can reliably predict rates five years out.

Who Might Choose an ARM

ARMs tend to suit buyers who expect to move or pay off the loan before the fixed period ends, who have rising income, or who have enough room in their budget to absorb a worst-case payment. They are riskier for households with tight budgets and no flexibility. A good test: could you comfortably afford the payment at the maximum cap rate? If not, the lower initial payment may be a trap.

Also compare the ARM discount to the fixed rate. If the ARM rate is only 0.25% to 0.5% lower, the savings may not compensate for the risk.

Questions to Ask the Lender

What is the index and margin? What are the initial, periodic, and lifetime caps? Is there a prepayment penalty? What is the fully indexed rate today? What would the payment be at the cap? Compare the loan estimates from several lenders, and look at the APR and the worst-case payment as well as the starting payment.