Fixed Rate vs. Adjustable Rate Mortgages: What to know before you decide

In this article, we will explain the features of a Fixed Rate and Adjustable Rate Mortgage so you can make an informed decision when determining which is best for you.

Fixed Rate Mortgage

Fixed rate mortgages feature interest rates that do not change over the life of the loan (e.g. 30 years). Accordingly, the associated principal and interest payment will remain fixed for the life of the loan.

Longer dated fixed rate loans are often best suited for individuals who intend to remain in their home for more than 10 years or for those who intend to hold and lease a property.

The shorter dated fixed rate loans can be great for those borrowers who can afford to pay down their mortgage in less than 20 years. These shorter term fixed rate loans come with a lower interest rate, but because you are paying down the loan over a shorter period of time your monthly payment will be higher than a longer dated fixed rate product (the payment schedule is referred to as the “amortization schedule”).

Adjustable Rate Mortgage (ARM)

An ARM is a loan with an interest rate that changes periodically, usually in relation to an index, and payments may go up or down. The most common ARMs are called hybrid ARMs because they contain both fixed and adjustable rate components. They carry 30 year repayment terms.

The basic features of an ARM are:

Initial Rate and Payment: The initial rate and payment amount on an ARM will be fixed for a specific period as stated in the product (e.g. on a 5/1 ARM, the initial rate remains in effect for 5 years).

Adjustment Period: After the initial fixed rate period, the interest rate and monthly payment can change (increase or decrease). The “1” in the naming of the ARM refers to how frequently an ARM rate can change after the initial fixed period. So a 7/1 ARM has a 7 year fixed initial period followed by annual adjustments.

Index and Margin: The interest rate on an ARM in the Adjustment Period is comprised of two numbers: the index and the margin. The index is a benchmark interest rate set by a third party that changes based on general market conditions. The lender will alert you which index will apply to your loan when you apply, but it is typically the one-year London Inter-Bank Offer Rate (LIBOR) or one-year US Treasury.

The margin is an interest rate premium that the lender adds above the index. The margin is set by the lender at the time you apply for the loan and stays the same over the life of the loan. The margin plus the index is referred to as the “fully indexed rate.”

Interest Rate Caps: Caps, or limits, dictate the maximum amount your interest rate can increase. If the index rate moves up, your interest rate will also move up. However, the total amount your interest rate can go up is limited by the “cap” associated with the product.

If interest rates go down, your interest rate could go down. However, not all ARMs adjust down. Some ARMs have “floors” which prevent the rate from dropping below the stated floor amount and often this floor is equal to the margin.

The lender sets the cap and/or floor when you apply for the loan.

Interest Rate Caps come in two versions:

  1. A periodic adjustment cap, which limits the amount the interest rate can adjust up or down from one adjustment period to the next, and
  2. A lifetime cap, which limits the interest-rate increase over the life of the loan.

Let’s use a hypothetical example to explain how an ARM will work:

The product is a 5/1 ARM with an initial rate of 4.0% percent and an adjustable rate of LIBOR (the index) + 2.00% percent (the margin). The periodic adjustment cap is 2.00% and the lifetime cap is 6.00%

In this case, 5/1 means that the initial rate of 4.00% will be fixed for the first 5 years, and the rate will adjust every year starting in year 6.

At the beginning of the sixth year of your loan, your rate will adjust. Let’s assume that the One-Year LIBOR index is 3.0% at that time soyour new rate at the first adjustment will be 5.0%. Here’s the math:

3.0% (LIBOR) + 2.00% (margin) = 5.00% (fully indexed rate)

At the beginning of the seventh year of your loan, your rate will adjust again (and every year thereafter).

Now, let’s assume the LIBOR is 4.5%. Your new rate would be 6.00%.

4.5% (LIBOR) + 2.00% (margin) = 6.00% (lifetime cap comes into effect here)*

*You are probably asking how 4.5% + 2.00% does not equal 6.50%? Remember, the lifetime cap is 6.00%, so the fully indexed rate cannot go above 6.00% at any point during the life of the loan.

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