A fixed rate mortgage offers stable monthly payments that never change since the interest rate remains the same throughout the term of the loan. Common loan terms for fixed mortgages are 15, 20, and 30 years. Fixed rate mortgages generally have higher interest rates than adjustable rate mortgages since the lender is committing money for a longer period of time. These types of loans may be more difficult to qualify for than adjustable-rate loans. The general rule of thumb is that fixed rate loans are ordinarily considered a better deal whenever the spread between fixed and adjustable rates narrows to 2 percentage points or less.

An adjustable rate mortgage (ARM) begins with a lower interest rate than a fixed mortgage, but can rise over time along with the payments if interest rates rise. The interest rate will vary based on an index plus the lender's margin. ARMs may have a teaser rate that is advertised but this is generally an introductory interest rate for promotional purposes. This rate is usually adjusted upward quite quickly.

The index is a floating interest rate that is set to a standard. Common standards include the interest rate on short-term U'S. Treasury debt securities and the Libor, the London Interbank Offered Rate, which is the rate banks charge each other for short-term funding. (Over 75% of ARMs are priced off the Treasury one-year constant maturity.) The margin is a fixed percentage rate that the lender adds to the index to arrive at the borrower's interest rate for the period.

In addition, most ARMs have a periodic rate cap. This cap limits the amount by which a borrower's interest rate can increase from one period to the next (i.e. 1-2%). ARMs also have a lifetime cap, which is the maximum interest rate the lender can charge over the lifetime of the loan (i.e. 6%).

ARMs may make sense for borrowers when fixed rates are high and borrowers are not planning on staying in their house very long or for those who are anticipating on refinancing later. ARMS are also popular loans for borrowers who need to stretch to afford a home. However, decide whether the initial savings on an ARM is worth the higher risk if rates go up considerably. These loans make sense for people who don't plan to stay in their home more than five years.