Fixed Rate vs. ARM

There are many different options available when shopping for a mortgage, but one of the most basic choices potential borrowers face is the choice between a fixed rate or an adjustable rate mortgage.

There are benefits and drawbacks to each, and you should consider these when shopping for a mortgage.

A fixed rate mortgage has the advantage that the interest rate is fixed for the life of the loan. Your payments will remain stable, regardless of changes in the real estate or interest rate markets. Over the life of your loan, the interest rate market will fluctuate, and at some point, your interest rate will probably be below the current market. The lender assumes the risk of such market fluctuations in making the fixed rate mortgage for you, and in exchange, the fixed rate mortgage typically carries a higher rate than a comparable adjustable rate mortgage.

An adjustable rate mortgage (ARM) offers a lower initial interest rate than its fixed rate counterpart. The reason for this is that making a mortgage involves a large sum of money being lent over a long period of time, and therefore carries some level of risk for the lender. If you take on an adjustable rate mortgage, you are assuming some of that risk by allowing your interest rate to change with the market. The lender's profit margin is protected over the life of the loan, and therefore they can offer you a more attractive interest rate.

Most homeowner sell or refinance their homes within 5 years, therefore obtaining a fixed rate may not always be the best option. When you are looking to buy a new home or refinance your existing mortgage sit down with your mortgage professional to find out all of the advantages and disadvantages to both a fixed rate home loan and an adjustable rate home loan for your individual situation. Adjustable rate mortgages, also referred to as ARM's, can be highly advantageous when used in the right situations. Remember to, that with an adjustable rate mortgage your rate can also go down depending on the market conditions at the time of the adjustment periods.

Both fixed rate and ARM loans can be "interest only". Typically, the interest-only period on a 30-year fixed rate loan lasts 5 years. On adjustable-rate mortgages, the interest-only period typically coincides with the fixed-rate period (if the loan is a 2-year ARM, the interest-only period is usually 2 years as well).

Mortgage loans with long fixed rate periods usually have higher interest rates. However, in certain interest climates, the short term rate is at the same level as long term rates. In such economic conditions, there is little to no difference in interest rates between an Adjustable Rate Mortgage (ARM) and a Fixed Rate Mortgage )FRM).

Fixed Rate Mortgages are often thought of as having high monthly payments and little to no flexibility compared to their ARM Adjustable Rate Mortgage brethren. In recent years, many people have voted with their feet and refinanced into record numbers of exotic mortgages, such Option ARM mortgages, because these adjustable rate mortgages allowed them to defer interest and pocket excess cash flow. However, in today's rising interest rate environment, many borrowers who are in the original, 1 month MTA or LIBOR variety of these adjustable rate mortgages are seeing dramatic increases in their underlying interest rates. When an option ARM loan's rate increases (the actual rate, not the minimum payment rate), the negative amortization caused when you defer interest each month increases, and your loan will "recast" or reset to a full payment, much more quickly. At today's rates, the typical option ARM loan taken out in 2004 or 2005 will recast in the next several months, often with no real notice to you. Don't get caught with your pants down on this, the payment can more than triple in some cases. Before your Option ARM loan recasts, consider locking in a low fixed rate loan with a cash flow option, which will minimize the negative effects of the interest you choose to defer and prevent any nasty surprises in the future.

During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal. A typical 30 year fixed rate mortgage takes 22.5 years of level payments to pay half of the original loan amount.

» DISCLAIMER: The information contained in this article on 'Fixed Rate vs. ARM' is a collection of contributions by licensed mortgage professionals and is not the opinion of Broker Outpost LLC. Always consult a licensed professional before applying for a mortgage.