Fixed Rate vs. Adjustable Rate Mortgage (ARM) Interest Rate

Fixed Rate vs. Adjustable Rate Mortgage (ARM) Interest Rate

At times, there is little difference between Adjustable Rate Mortgage (ARM) start rates and Fixed Rates. Sometimes, there are significant rate spreads between the two. In times of overall low rates, the differences tend to be minimal. Since all rates are low, there is only so much “room” between the rate level and zero. Therefore, as in the years 2002 through 2006, all mortgage rates were very low (5-6%), leaving little space to have a large difference between fixed rates and ARM's.

However, in periods of either rising and/or high rates, the difference between the two can be of serious importance, sometimes two to three per cent. This occurs because the published fixed rate must protect the mortgage lender from even further rate increases as much as possible, while the ARM lender can publish a lower discounted rate, knowing that the rate adjustment terms will allow them to increase the rate in the future, bringing them closer to market rate.

If you believe you will keep your home and the mortgage for the long-term, you may be better selecting a 30 year fixed rate loan so you can budget properly and will not be subject to future unpleasant rate increases. Should you be unsure of how long you'll keep the real estate and/or if the difference in interest rates is small, you might also be wise to choose a fixed rate product.

In periods of rising rates or high fixed rates, you might benefit greatly from an ARM. But – you must examine the ARM parameters and terms carefully. To compare the two choices properly, use the following analysis:

• How often does the loan adjust (re-price)? One, three, five years?
• What is the Index? – the third part rate that is the basis for your rate changes. The most common are the U.S. Treasury Bill Index, the LIBOR (London InterBank Offered Rate), and the 11^th District Cost of Funds (COF).
• What is the Margin? – the percentage that will be added to the Index to come up with your new rate at every adjustment period.
• What is the Adjustment Rate Cap? – the maximum your rate can increase at each adjustment period. This cap is often two per cent.
• What is the Lifetime Rate Cap? – the maximum your rate can increase above the start rate over the life of the loan. This cap is often six per cent.
• Do some math. Using a pencil and paper, make at least a quick calculation of your future cost IF the rate increases to the maximum at every adjustment period until it reaches its lifetime cap. Then use that maximum rate to compare to the fixed rate you can get today to compare.
• Based on the amount you want to borrow, do your savings in the first years of the ARM loan offset the future increases (at this worst case scenario) when compared to the cost of the fixed rate loan?
• Compare the fixed rate and start rate of an ARM. Then look at the ARM worst case (lifetime maximum) versus the fixed rate percentage. Is the difference significant to you? In your favor?