How ARM differs from Fixed Rate Mortgage

Sam · Last edited by Sam on Thu Oct 16, 2008 9:41 pm

Choosing the right kind of mortgage is indeed a tedious job. With lenders and financial institutions providing a wide range of home loans these days, borrowers get confused as to which will suit them the most. Not only are there various kinds of mortgages, but they come with different rates and terms. So it becomes difficult for a borrower to understand the pros and cons of the options available in the market.

The most common types of mortgages are fixed rate mortgage and adjustable rate mortgages (ARM). The former offers rate that do not change throughout the loan term. But an ARM initially provides fixed rate, after which it varies as the indexed rate fluctuates from time to time. There are various aspects on which these loans differ. We provide you with a list of differences between them so that you can easily decide between the two.

Interest Rate:
A fixed rate mortgage sets a guaranteed rate throughout the loan term even if there is an increase in the market rate. But an ARM offers a fixed rate for the first few years of the loan period, after which it changes periodically.

The interest rate in a fixed rate mortgage is set with respect to the market rate. An ARM, on the other hand, follows an interest rate that is applied by adding a margin to an indexed rate like the Prime Rate, COFI, CODI, LIBOR etc. The margin remains constant till the life of the loan.

With ARMs offering low initial fixed rates compared to prevailing rates of fixed rate mortgages, borrowers can easily qualify for such loans. Those who wish to occupy their home only for a few years benefit from this aspect of ARM. They can start off with low monthly payments. As rates are adjusted, they can pay off their loans with higher interest rates within a short time frame. That is why several borrowers prefer to shift from fixed rate to an ARM.
Cap:
The provision of cap in ARM prevents the interest rates from increasing or decreasing beyond a certain level. The rates cannot change beyond a specified limit or cap in each adjustment period and throughout the life of the loan. This prevents borrowers from paying higher interests that could be possible in the absence of cap.

There is also a payment cap that limits the amount of monthly payments in an ARM. A fixed rate mortgage does not use a cap as the applied interest rates do not fluctuate from time to time.
Monthly payments:
Fixed rate mortgages offer monthly payments that remain constant throughout the entire loan period. So borrowers may curtail other expenses to save cash for paying off their mortgage dues. But they cannot take advantage of low market rates as their monthly payments are based on a predetermined rate. In this regard they can benefit from an ARM when the indexed rates go down. But with interest rates getting higher, borrowers have no option but to make higher mortgage payments in an ARM.
Comparative analysis:
Fixed rate mortgages range from 30 year, 15 year to bi-weekly payment and convertible mortgages. These mortgages vary according to their payment schedules and plans. Similarly there are various options for adjustable rate mortgages. These are 1 year, 3 year, 5 year adjustable rate mortgages, etc. The interest rates on these mortgages adjust annually or after every 3 or 5 years respectively.

There are also 3/1 and 5/1 ARMs with interest rates remaining fixed for the first 3 and 5 years respectively. But at the end of the fixed rate period, the rates adjust annually according to the indexed rate. This continues till the life of the loan. Apart from these ARMs, there are also the option ARMs offering various monthly payment options like minimum payment, interest-only payment, and fully amortizing 15 year and 30 year payments respectively.

Both fixed rate and adjustable rate mortgages have various pros and cons. A fixed rate mortgage is often preferred because borrowers can know much they will pay on a monthly basis. But when market rates are high, ARMs are widely acceptable as there is a possibility of rates decreasing in the near future. ARMs are also helpful as their start off rate is lower than that of fixed rate mortgages. However apart from the interest rate, a borrower needs to consider various other factors before choosing the right kind of mortgage.

Guest

What has been the Prime Rate over the last 5 years?

jameshogg · Posted: Fri Jun 16, 2006 1:34 pm Post subject:

Hi,

You can check hsh.com for the index rate history.

James

Samantha · Posted: Fri Jun 16, 2006 2:33 pm Post subject: Index Rate

Hi David,

Welcome to MortgageFit Forums.

In an ARM, the index and the margin are the two main factors to set the rate that you pay.

The index rate is set by market forces. It is published by a neutral third party.

Margin is added to the index to find out your rate. It is an agreed upon number of percentage points.

The following graph shows the performance of the six most popular adjustable rate mortgage indexes over the last 5 years -

God bless you.

For MortgageFit,
Samantha

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