Which Mortgage Loan Type, Fixed or an ARM?
When deciding on a mortgage, you may be thinking about an ARM rather than a traditional fixed rate. An ARM is an adjustable rate mortgage, which means your payments can change. When you start paying the loan, depending on which ARM you choose, your payments stay the same for 3, 5, 7 or 10 years, depending on the period of length you wish to have your rate locked in for. It’s exactly like a fixed rate mortgage except after the initial fixed period, your payment and interest rate are then linked to a market index and margin, hence the adjustable part of the loan.
ARM’s are advertised using numbers such as 3/1 or 10/1. The first number is for the initial fixed rate period in years. The second number indicates the adjustment interval in years. A 5/1 ARM means the loan starts as a fixed rate for 5 years and then once a year, the interest rate is open to adjust. To protect you, ARMS come with specified caps that limit how much the interest rate can change, regardless of how high the market index may increase. Market indexes are interest rates we see in the news, like the Treasury Bill, LIBOR or even the Prime Rate. These change with the winds of the economy.
If your mind is closed to an ARM, you’re not alone, and so read no further. If you’re open to it, you could be thinking about:
- The initial interest rate is lower than a fixed. For example, as of early March 2014, on a 7/1 ARM for $200,000, you will save $1,372 in the first year compared to a fixed rate. This can be tempting. On a 3/1 ARM, the savings in the first year is $2,035.
- The certainty of selling your home before the payments can change.
- Your financial advisor, looking at your lifestyle and financial future, may recommend an ARM.
A lingering thought, left over from the crazy foreclosure days last decade, is that ARMs are confusing, designed to be enticing, come with incomprehensible disclosures and then steal your equity. While some of this is true, it was based on an ARM product no longer offered in the market place. IN fact that particular program, referred to as an “exotic ARM” may as well be called an “extinct ARM” as it left the market place even before new tough government regulations were passed. What is also true is many people didn’t understand those products and it helped lead to much of the programs decline.
Today’s ARM’s are understandable and un-exotic. Just like a fixed rate mortgage, today’s ARMs will not increase the principal you owe. If you’re interested in one, by law you will be given all the facts in numerous disclosures. The basics are the amount and length of your initial lower payment-period, the payment caps that prevent future payment shock and your plans for how long you will be in mortgage.
An ARM’s biggest benefit is the start rate being lower than that of it’s fixed rate mortgage counter parts. This lower start rate will not only lower your monthly payments but also reduce the balance faster helping you grow your equity in the property you buy.
Here is an example, with all other terms equal, comparing an ARM’s and a fixed rate on a $200,000 mortgage over a 30 year term:
|Rate P & I Payment Balance in 3 years Balance in 7 years|
|Fixed Rate: 4.5% $1,013 $189,869 $174,052|
|7 Year-ARM: 3.5 $ 898 $188,070 $170,089|
|3 Year-ARM: 3.0% $ 843 $187,080 UNPREDICTABLE, BUT IT WON’T INCREASE|
Looking at the future balances, relative to a fixed rate loan, this is another way an ARM can save money, provided you sell or refinance before a possible rate increase.
At the end of the day, you may find an ARM logically suitable but still not want it. You may prefer certainty. Fixed rates are still at historically low levels, and while it is nice to have the lower rate to start that an ARM provides to some it’s nice to know that with a fixed rate you payment will never change.