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How ARM differs from Fixed Rate Mortgage

Posted on: 02nd Apr, 2004 04:45 am
Choosing the right kind of mortgage is a difficult job. With banks and lenders providing a wide range of home loans, borrowers can get confused about which mortgage will suit them the best. 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 on the market.

The most common types of mortgages are fixed rate mortgage (FRM) and adjustable rate mortgages (ARM). An FRM offers a rate that does not change throughout the loan term, but an ARM has an initial low interest fixed rate, which increases with time. Below is a comparison of the two types of mortgages.
  • 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 in the beginning, but after that, it will increase periodically.

    The interest rate in a fixed rate mortgage is set with respect to the market rate at the time the mortgage is taken out. 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 for the life of the loan.

    With ARMs offering low initial fixed rates compared to prevailing rates on fixed rate mortgages, borrowers can easily qualify for these loans. Those who wish to occupy their home for only a few years benefit from this aspect of an ARM. They can start off with low monthly payments, and as rates are adjusted, they can pay off their loans at higher interest rates within a short time frame. That is why some borrowers prefer to shift from fixed rate to an ARM.

  • Cap:
    The rate cap provision on an ARM prevents the interest rate from increasing or decreasing beyond a certain level. This prevents borrowers from paying excessively higher interest rates.

    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 because the interst rate does not fluctuate.

  • 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 to pay off their mortgage debt. But they cannot take advantage of lower market rates as their monthly payments are based on the rate at the time the loan was taken out.

  • Comparative analysis:
    Fixed rate mortgages range from 30 to 15 year term loans. Their payment options vary from bi-weekly payments to month-to-month. Convertible mortgages help borrowers switch from an ARM to a FRM. Similarly there are various options for adjustable rate mortgages. These are 1 year, 3 year, 5 year adjustable rate mortgages which means 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 where the interest rates remain 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 and continue for the life of the loan. Apart from these mortgages, there are also ARMs offering various monthly payment options like minimum payments, interest-only payments, and fully amortizing 15 year and 30 year payments.
Both fixed rate and adjustable rate mortgages have various pros and cons. A fixed rate mortgage is often preferred because borrowers know how much they will pay on a monthly basis. But when market interest rates are high, ARMs are preferred because they offer a way for low income buyers to get a home. However apart from the interest rate, a borrower needs to consider various other factors, like their income, before choosing the right kind of mortgage.
What has been the Prime Rate over the last 5 years?
Posted on: 16th Jun, 2006 01:18 pm
Hi,

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

James
Posted on: 16th Jun, 2006 01:34 pm
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
Posted on: 16th Jun, 2006 02:33 pm
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