Fixed vs adjustable-rate mortgage: run the reset test first

How an ARM resets

At each adjustment, the new rate is the index plus the margin, limited by any caps. The CFPB explains each part:

• Index: an interest rate that moves with general market conditions. The lender chooses the index when you apply, and that choice generally will not change after closing.
• Margin: the number of percentage points the lender adds to the index. It is set in your loan agreement and will not change after closing. The CFPB notes margins can vary a lot between lenders and can be negotiated.
• Caps: limits on how much the rate can rise at the first adjustment, at each later adjustment and over the life of the loan. Some loans also limit how far the rate can fall.

The sum of index and margin is called the fully indexed rate. If it is higher than the cap allows, the cap applies.

What the names mean

ARMs are often described with two numbers, such as a 5/6 or 7/1. The first number is the length of the initial fixed period in years. The second describes how often the rate adjusts afterward, for example every six months or every year. Read the Loan Estimate and the loan's adjustable-rate disclosure to confirm, because naming conventions vary.

The CFPB's warning about plans

The CFPB's tip is direct: do not assume you will be able to sell your home or refinance before the rate changes. Your property's value could decline, or your financial situation could change. It suggests that if you cannot afford the higher payments on today's income, you may want to consider another loan.

Five questions to decide

1. How long do you realistically expect to keep this loan, and how confident are you?
2. What is the payment at the lifetime cap, and does your budget survive it?
3. How much does the ARM save during the fixed period, in total dollars?
4. Do you have savings that could absorb a few years of higher payments?
5. Does the ARM have features you would not accept in a fixed loan, such as a prepayment penalty?

The CFPB's own list for ARMs adds: know how high and low the rate and payments can go at each adjustment, how often the rate adjusts, how soon your payment could rise, and whether there is a cap and a floor.

Fixed loans have trade-offs too

A fixed rate removes payment risk from principal and interest, but not from property tax and insurance, which can still rise through escrow. And if market rates fall, a fixed-rate borrower needs to refinance, with its costs, to benefit. Neither type is right for everyone.

Run your own numbers

Use the calculator below with your Loan Estimate figures. Enter the starting rate, the reset rate you want to test, the length of the fixed period and the term. Try the lifetime cap first. If that payment fits, an ARM may be reasonable for you; if it does not, choose the fixed loan or a lower price.