If you’re considering buying a new home, it’s important to understand the different types of home mortgage loans available to you. One of the biggest questions borrowers must ask themselves when applying for home financing is whether a fixed-rate loan or adjustable-rate mortgage (commonly known as an ARM) is the right call.

Fixed-rate mortgages lock in an interest rate that remains static for the life of the loan. With an ARM, however, the interest rate is adjusted at different periods and therefore fluctuates over the life of the loan. Following an initial period – often five, seven, or ten years (options known as 5/1, 7/1, and 10/1, respectively) – during which the rate remains unchanged, the interest rate on an ARM is adjusted annually according to an index used by the lender, such as the LIBOR or 1 Yr Treasury Bill.

Obviously, with an ARM, there is more risk involved for the borrower once the initial interest period has expired, but since the initial rate is usually very attractive, ARMs do hold appeal for certain borrowers. While rates can fall, they can also rise, and this is a gamble the borrower must take. It’s important to understand that after the initial interest period, a rise in the loan’s interest rate means larger monthly payments for the borrower. However, ARMs also generally set a cap on how much the rate can fluctuate in either direction during different adjustment periods on the loan. Here’s an example:

A 2/2/5 rate cap on a 7/1 ARM would stipulate that the rate may not rise or fall more than two percentage points after the initial seven-year term (represented by the first 2), nor may it increase or decrease more than two percentage points annually following the first rate adjustment (indicated by the second 2). The final 5 in the 2/2/5 sequence is the lifetime cap, signifying that the rate may not vary by more than 5 percentage points in either direction during the entire life of the loan.

While many borrowers may crave the stability and certainty associated with the set monthly payments on a fixed-rate loan, there are some circumstances in which an ARM might be a better option. Here are a few:

·       If you’re in the position to pay off your home loan long before its 15- or 30-year term is up, an ARM might not be a huge risk. By paying off the loan substantially early – especially before the initial rate even expires – you won’t incur a potentially higher rate for long … or even at all.

·       If you are confident in your ability to refinance to a fixed-rate mortgage after the initial interest term expires, you might be able to capitalize on the attractive rate at first, thus saving some money up front before refinancing. It’s important to note, however, that refinancing is not necessarily a sure bet, especially if fixed interest rates end up skyrocketing or your credit score takes a beating, rendering you ineligible for a fixed-rate loan with a good interest rate.

·       If you don’t plan on staying in a home for a great length of time, an ARM might save you money in interest before you turn around and sell – or flip – the property.

·       If you are comfortable with the caps set on your ARM and feel that you can make payments even if the rate increases, it may be worthwhile to take a chance that could also potentially result in a lowered rate.

If you’re considering applying for a mortgage loan, you’ll want to take a look at the different fixed-rate and ARM options with your lender. Have a conversation with your loan officer to help determine what type of loan is right for you. He or she will be able to look at your personal financial situation and help you decide whether an ARM is your best choice.