May 7, 2010, Newsletter Issue #217: Fixed Rate vs. Adjustable Rate Mortgages

Tip of the Week

What’s in a name? Beyond the obvious, one rate remains the same while the other changes, there is no difference in the basic terms of either mortgage type. However, understanding the way an adjustable rate mortgage (ARM) works is very important to your decision making. While the start rate is the same as the rate for the next 30 years in a fixed rate mortgage, the beginning rate is only one component, sometimes a relatively minor component, in an ARM. The terms of an ARM are critical to its desirability. Your future plans for the property being purchased also must be incorporated into your decision of a mortgage type.

If you plan on keeping your new property (or your new mortgage) for the long-term, at least five years or longer, you might be better off with a fixed rate mortgage. The rate will not change, for better or worse, for the entire term of the loan, usually 30 years. If your household income is consistent and should remain so, a fixed rate loan provides the security of an amount that is easily budgeted, regardless of fluctuations in the economy. If you can afford the loan now, you should have the ability to afford it in the long-term.

Should you be considering your new real estate purchase as more short-term, five years or less, you might want to consider using an ARM to finance your home. In the beginning it will definitely cost you less and, in the short-term future, with reasonable adjustment and lifetime caps, it may cost you considerably less, too. There are four major components to an ARM (in addition to the start rate), all of which you must understand to make an intelligent decision about the loan type you want. The components you need to examine:

Index: the base number used to calculate future rate changes. The most common indices are the U.S. Treasury Bill average rate, the 11th District Cost of Funds (COFI), and the LIBOR (London Interbank Offered Rate), none of which fluctuate rapidly or often. Margin: the percentage that will be added to the index at the rate change date to calculate the new interest rate for the coming period. Adjustment Cap: the maximum your interest rate can increase at each adjustment period. The most common cap is two per cent. Lifetime Cap: the maximum your interest rate can increase over the total life of your mortgage loan. The most common cap is six per cent. ARM ’s come in a wide variety of choices: six month, one year, two year, three year, and five year ARMS are the most common products offered. All are usually full 30 year mortgage loans but revert to one year ARMS after the initial adjustment period, whatever it may be. It should be evident that, depending on the length of time before the first adjustment period, the start rate, while important, has a different level of significance. The start rate of a three or five year ARM is much more important than that of a six month or one year ARM.

For instance, if you opt for a 3/27 mortgage loan, your initial interest rate is fixed for the first three years and reverts to a one year ARM for the remaining term. If you plan on keeping your property or this mortgage for three to four years, this product should be an excellent choice. Should you plan to keep the mortgage for five to ten years minimum, you could find the interest rate up to six per cent higher in as little as six years. If you started at 5.5% (when the fixed rate was 6.5%) you could be at 11.5% in six years. Remember, should that happen, the fixed rate will also be much higher than the 6.5% you could have received at the beginning, so refinancing may or may not make sense.

In summary, think about your future plans for the property and the mortgage before you select the mortgage type you want. Understand the potential risks and rewards you might receive from each before you commit to one course of action or another.

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