ARMs vs. fixed mortgages

by Elizabeth Rosen, Contributor

The mortgage rate is the fee you pay in order to borrow money from a lender.

When you buy a house using a loan, you will have to decide whether you want a fixed mortgage rate or an adjustable mortgage rate. The rate is expressed as a percentage of the loan, such as 5%. It is important understand the differences between fixed mortgages and adjustable-rate mortgages, since they can greatly affect your financial future.

Fixed rate mortgages A mortgage loan with a fixed rate is one in which the interest rate remains the same over the entire term of the loan. You “lock in” an interest rate when you initially borrow the money, and that is the rate you pay for as long as you have the loan. The main advantage to a fixed mortgage is that you always know what your payment will be. It does not fluctuate with market conditions. Additionally, if you get your fixed mortgage when interest rates are low, you are protected from increases to interest rates later on. The downside to having a fixed mortgage is that you are paying a higher interest rate than the rest of the market if national rates drop. In order to take advantage of falling interest rates, you have to refinance ― and determine whether the origination fees and other costs associated with refinancing will be offset by the lower interest rate.

Adjustable rate mortgages (ARMs) Unlike a fixed mortgage, where the rate remains the same throughout your loan term, an adjustable mortgage rate changes as the market does. The interest rate for an adjustable-rate mortgage is periodically re-set based on the performance of a mortgage index. In general, a lending institution will use one mortgage index for most of its products. While there are many different indexes used by lenders around the world, the following 5 mortgage indexes are the most commonly used in the United States:

  • Prime Rate (The Federal Reserve’s U.S. Prime Interest Rate)
  • LIBOR (London Interbank Offered Rate)
  • COFI (11th District Cost of Funds Index)
  • CMT (Constant-Maturity Treasury)
  • MTA (12-Month Treasury Average)

Make sure you know which index your lender is using ― this usually established during loan application. If the index’s value rises, your interest rate and monthly payments will increase as well. This means that for every payment period, you will owe a different mortgage payment amount, depending on the interest rate. The main advantage to adjustable-rate mortgages is that they generally have lower rates than fixed mortgages. Also, if the market goes down, your mortgage rate (and your mortgage payment) decreases as well. However, if the market improves, you will find yourself making higher mortgage payments as interest rates rise. With ARMs, mortgage lenders can offer low initial rates in exchange for sharing the future risk of higher interest rates with the borrower. Some lenders offer rates that are fixed for a certain number of years (such as 1, 3, 5, or 7) before they become adjustable. It is important to understand the specific terms of such loans, since some may require a balloon payment at the end.

Bottom Line Before you decide which type of mortgage loan is best for you, it is a good idea to carefully consider the options and their implications. You should also be certain that you have enough income to cover possible mortgage rate increases if you decide that adjustable is the way to go.