ARM vs. Fixed Rate Mortgage – Differences, Pros And Cons


So, you’re ready to invest in your new home.

Let me guess:  you’re weighing the merits of an adjustable-rate mortgage (ARM) and a fixed-rate mortgage.  How are they different from each other and more importantly, which one is best for you?

 

ARM vs. Fixed Rate Mortgage - Differences, Pros And Cons

The Interest Rates Difference

When you choose a fixed-rate loan, it is obvious that the interest rate will not change.  An adjustable-rate mortgage, as its name implies, resets and repackages its interest rate at specific intervals.  Nevertheless, it can be advantageous for homebuyers with specific goals.

With an ARM, you start off with a set interest for a specified period of time.  Then, the lender will periodically adjust the rate after that period.  Sometimes, you will see the notation “5/1” in your ARM; this means that the rate will be constant for five years and then the lender will adjust it annually afterward.  Currently, some lenders are extending the initial rate lock period from the traditional 5 years to 7, 10 or even 15 years.  This makes the ARM even more attractive than other types of mortgages.

Index plus Margin

When the initial fixed-rate period is over, the lender will use the formula ‘index plus margin’ to set your interest rate.  For the index, they can use a published interest rate as LIBOR (London Inter-Bank Offer Rate) or a private interest rate from the lender.  The margin is usually a small markup on the rate which the lender will determine.

In many cases, the ARM interest rates are initially lower than a 30-year fixed-rate loan (often by as much as one percentage point), but you should remember that an ARM rate may reset higher several times over the life of the loan.

Why Pick an ARM?

If you’re the kind of the first-time homebuyer who is dynamic and wants to keep your options open, an ARM may work better for you.  As long as you’re prepared to move on before the introductory period ends, you’ll probably maximize the advantage of making lower payments for your house.  Here’s a bonus:  since your lender will qualify you based on your lower monthly payment, you could qualify for a higher-priced house than you would with a fixed-rate mortgage.

Here’s how it will go:  after you’ve completed your initial period, the lender will determine your new rate.  They will base it on an index, which will act as the new benchmark interest rate, plus their set margin amount to calculate the new rate.

Now, the new rate will either increase or decrease your monthly payments – which may appear to be a bit risky if you are a conservative borrower.  The good news is, most ARMs have limits on how much the lender can change the interest rate (therefore the monthly payment) at the end of each adjustment period or over the term of the loan.  On top of that, should market conditions push the rates down, it will be to the advantage of the ARM borrowers.  So, before you sign on the dotted line, give careful consideration to the initial rate, initial rate period, and the adjustment periods when assessing an ARM.

Advantages of ARMs

There are a few reasons that sway homebuyers to opt for an adjustable-rate mortgage.  Here are some of them:

Lower Initial Interest Rate

ARMs typically carry a lower initial interest rate when compared to a 30-year fixed mortgage.  With an ARM, you pay the same interest rate for the initial three, five, seven or ten years.  After that period, lenders change it semi-annually or annually for the rest of the 30-year loan period.

Take note that the interest rate during the initial period for an ARM is lower than the rate on a fixed-rate or interest-only mortgage.  This is why many finance experts call this a starter or teaser rate because it entices borrowers to sign up for a loan.

The low initial interest rate for an ARM helps in getting a mortgage and acquiring a home more cost-effectively than with other loan or mortgage products.

Flexibility

An ARM would be more suitable for you if you are strongly anticipating a major life change in the next few years, like moving or selling your house.  You can take advantage of ARMs fixed-rate period and sell the house before it expires and the unpredictable interest rate phase begins.

Lower Initial Monthly Payment

It’s simple:  if you get a lower initial interest rate with an ARM, you’ll pay less initial monthly mortgage payments.  Lower monthly payments will save you money on your total monthly housing expense.  More savings means more financial flexibility when you buy a home or refinance your mortgage.

Of course, the rate can increase during the life of the loan (and so will your monthly payments) – that’s a fact.  The bottom line is this:  a lower initial payment can give you additional financial breathing room when you need it the most.

Rate and Payment Caps

Here’s another good thing about ARMs:  it might have several types of caps that limit the spikes on your mortgage rate and the size of your payment.  These would include interest-rate caps or limits on how much the rate can change each time it adjusts and on the number of rate change over the loan’s term.

There’s also the cap on how much the payment can grow each time the lender adjusts the rate.  You can ask your lender for an explanation of the risks and a sample computation of how much would your maximum payment be.

Mortgage Rate May Drop

While we’re on the subject, here’s another benefit of an ARM:  your mortgage rate may actually go down.  This is a good probability if the interest rates decrease.  When your mortgage enters the adjustable rate period, the rate changes on an annual or semi-annual basis.

During this period, you will have the fully-indexed rate, a rate that will fluctuate according to the movement of an index. This index could be the LIBOR or the treasury rate, two rates that move up or down according to the economic situation.  If the index goes up, your mortgage rate rises accordingly.  If the index goes down, your rate follows suit.  A lower mortgage rate brings down your monthly payment and saves you money.

Realistically, it is very difficult to predict how interest rates will behave several years in the future.  The nice thing is, when the rates eventually go down, an ARM will help you take advantage of it by giving you lower monthly interest and payment.

Why Choose A Fixed-Rate Mortgage?

Here’s a home buyer who has a stable career, lives and/or works in an area he truly loves and has decided to establish roots in that community.  Does that sound like you?  If it does, then a fixed-rate mortgage might interest you.  This kind of loan is also best suited for people who are near retirement.  Why?  Because the fixed payments make it easier for them to forecast their expenses.

Like any other product, a fixed-rate mortgage has its own pros and cons – especially when you place it head-to-head with an ARM or interest only mortgage.  On the plus side, you have the assurance that your interest rate and monthly payment will stay constant, flexible mortgage length options, and peace of mind.  On the minus side, it has a higher interest rate and monthly payment, and you lock yourself into the mortgage if you cannot refinance it.

Anyway, there are a few reasons that move homebuyers to opt for a fixed-rate mortgage.  Here are some of them:

Payments Remain Constant

In a fixed-rate mortgage, the lender amortizes the payment on that mortgage. Basically, the lender is computing for the total amount of the loan plus interest over the course of the loan. They then spread the total amount over the course of the loan or more specifically, divide it by the number of monthly payments you should make.

And because the interest rate will not change, this monthly payment amount will not change too.  Here’s the kicker:  your monthly mortgage payment on a fixed-rate mortgage will remain the same over the life of the loan but you might have to pay other expenses too.

You might have to shell out some cash for homeowner’s insurance premiums and property taxes, for instance.

Interest Rate Will Not Increase

You know that in an ARM, the interest rate can change every year.  This exposes the borrower for potentially unpleasant surprises that he may have to bear for an entire year.  Needless to say, your loan has the potential to become more and more expensive over time.

In a fixed-rate mortgage, you do away with that uncertainty.  Your advantage is that the interest rate will stay ‘as is’ for as long as you keep the loan active.  So, don’t expect any unpleasant surprises down the road.  Whatever rate the lender give you up front will be the same one you’ll have for the full 30-year term.

Comparing Loan Options is Easier

If you like things simple even when shopping for your loan, a fixed-rate mortgage should be your bet.  There’s hardly anything different between what various lenders offer – you just need to compare interest rates and closing costs.

With the ARM, you have to consider too many moving parts aside from closing costs:  introductory interest rate, length of the introductory period, how much the rate can change each period, and how much the rate can change over the entire loan term.

You could also opt for a graduated payment mortgage where you start with a lower payment and gradually pay more over time.

Flexible Mortgage Term Options

One thing that puts a fixed-rate mortgage over other mortgage programs is that it offers more flexible term options.  Lenders are making available for borrowers a range of terms including 10, 15, 20, 25 and 30 years.  You might even stumble upon a lender who will be willing to offer a 40-year term, albeit rarely.

With a fixed-rate mortgage, you will find that the interest somewhat follows the term:  shorter terms mean lower rates and longer terms mean higher rates. This is how it works:  a mortgage with a shorter term and lower rates lower your total interest expense over the life of your loan.

However, you will be, in effect, paying a higher monthly payment because you are paying back the entire loan over a shorter repayment period.  The good news is because you now have a range of terms to choose from, it will be easier to select one that closely meets your financial objectives.

Get a Solid Grasp on the Loan Terms to Choose the Right Mortgage

As you compare an ARM against a fixed-rate mortgage, you have to decide according to your situation.  If you like stable monthly payments and knowing exactly how your total interest would add up for the entire term of the loan, it’s fixed-rate mortgage for you. It could also be your choice if you intend to stay in the house even after the fixed introductory period is over.

But if you are planning to be in the home only for a few years, you could take advantage of an ARM’s lower introductory rate.  And if you foresee the interest rates to go down, getting an ARM will help your secure lower rates in the future, saving you the costs of refinancing.

Here’s the main point:  whether you determine a fixed-rate mortgage or an ARM is the best one for you, you need to understand all the details of the product.  Many times, what’s in the fine print will spell out what’s best for your home financing situation.