What is the Difference Between a Fixed Rate Mortgage and an Adjustable Rate Mortgage?

The difference between a fixed-rate mortgage and an adjustable rate mortgage (ARM) boils down to the interest rate over the term of the loan. A fixed- rate mortgage is exactly as it sounds: the interest rate is fixed. This means your interest rate for this loan will never change, which translates to your monthly payment being the same every month until it is entirely paid off. An adjustable rate mortgage does not have a fixed mortgage rate. In fact, the interest rate for an adjustable rate mortgage is only fixed for a certain amount of years and after that time is up, the interest rate will change once a year according to the market.

Fixed Rate Mortgage: Playing It Safe

There are numerous benefits to both kinds of mortgages, but a fixed rate mortgage is most definitely the more popular item of the two. A fixed rate mortgage is very popular amongst homeowners mainly because of the fixed interest rate and also because they can have 30 years to pay off their homes, which equates to a lower monthly payment. In addition to having a lower monthly payment, a fixed rate mortgage is stable. When getting your mortgage, you know exactly how much you will have to pay every single month, so you won’t have to worry about any surprises that you may not be prepared for. We never know what the future might bring, so many homeowners want to play it safe, especially if they have a family to provide for, and believe that stability is the most important thing for them.

 

ARM: Taking Advantage of Low Rates

An adjustable rate mortgage (ARM) is a little bit different than a fixed rate mortgage. A 5/1 ARM means that for the first five years of the mortgage, the interest rate will be fixed and then after the first five years are finished, the interest rate will then adjust once a year for the remainder of the term. Since an ARM is a hybrid mortgage, meaning that it involves both a fixed interest rate and an adjustable interest rate in the same mortgage, a lower interest rate is given during the initial fixed rate years than if you were to have gotten a fixed rate mortgage for the entire duration of your mortgage.

ARM: Lower Monthly Payments

If your number one priority when purchasing a home is to have a low monthly payment, an ARM might be the best option for you. With a 5/1 ARM, you could take advantage of the low monthly payments for the first five years and put aside as much money as you want into your savings during this time. If having a low monthly payment is the most important thing to you because you are not earning as much as you would like, an ARM is a great option that gives you the ability to afford your mortgage payments while also working on yourself, so that when the initial fixed rate period is done, you will be earning more to offset the higher monthly payment.

 

ARM: What If My Living Situation Is Temporary?

If purchasing a home has always peaked your interest, but at the same time is something that could never come to fruition in your mind because of constant relocating, an ARM could help you with that. Military families, employees of major airlines, professional athletes, and anyone else who is changing their post every several years because of their occupation are great candidates for ARMs. With a 5/1 ARM, the homeowner gets to take advantage of having a low interest rate for the first five years of your term, but if they already know that they will not be staying in their new home for more than five years, this type of loan works in their favor. Not only will they get to have low monthly mortgage payments, but before the adjustment period comes into effect, they will have already sold the house and paid back the remaining balance of the loan, and moved onto their next location.

Great Candidates Who Should Consider an ARM

You do not have to be in a professional field that requires constant traveling in order to be a good candidate for an ARM. If you are the type of person who simply wants to live in different parts of the United States for the sole purpose of having a change of scenery every several years, or if the idea of being stuck in the same location for 30 years has prevented you from purchasing a home, this is something that could not just suit your lifestyle, but it could help you with your quality of life.

Renting Doesn’t Have To Be the Only Option

Instead of having to rent an apartment or home in your different locations and having to answer to your landlords, you can have a home to call your own. You could have all the freedom to express yourself and decorate your home just the way you like it, without having to worry about whether or not you will be getting your full security deposit back.

You Can Still Play It Safe with an ARM

Even though we talked about stability being the main reason why people choose fixed rate mortgages over the other types of mortgages, you can be the type of person who values stability and security and still reap the benefits that a 5/1 ARM offers. While the fixed interest rate that comes with the 5/1 ARM isn’t permanent, the fixed interest period is still for 5 full years and the interest rate is lower than that of a fixed rate mortgage.

Different Types of ARMs to Cater to Your Needs

There are also different kinds of ARMs such as a 5/1 ARM, a 7/1 ARM and a 10/1 ARM, so if you want to take advantage of the benefits that come with an ARM, but at the same time would like to have a sense of stability and security, you can opt to have a 10/1 ARM and have the fixed interest rate for 10 years before the interest rate adjusts. Although the interest rate will start adjusting once the initial period is up, it only adjusts itself once per year and you can predict what the rate will be so that you can be prepared for your new monthly payment amount.

 

In order to do this, there are 4 crucial pieces of information that you will need:

 

  1. Interest Rate Index to which your ARM rate is tied
  2. Margin
  3. Adjustment Cap
  4. Lifetime Maximum Rate

Interest Rate Index

The Interest Rate Index is the reference point that is used to calculate the interest rate charged on your ARM as well as other financial products. Investors, borrowers, and lenders use this to determine the interest rates of the financial products that they sell or buy. The interest rate index also isn’t permanent and can fluctuate based on small changes to a single item such as the yield on the United States Treasury securities. There are multiple Interest Rate Indexes with names that sound very similar to each other, which is why it is important to know exactly which one your ARM is affiliated with.

Margin

The Margin is the amount added to the index in order to determine your rate.

Adjustment Cap and Lifetime Maximum Rate

The Adjustment Cap controls how your interest rate can adjust and the Lifetime Maximum Rate is pretty much what it sounds like: it is the maximum rate over the duration of the loan.

All of this information is in the paperwork that you will receive from your lender and there are many sources online that can help you to calculate your new payment in the form of an interactive calculator, or if you are more old fashioned and prefer doing it manually, there are printable worksheets available as well as a detailed set of instructions. If you want to seek a professional’s help, there are services that will also help you with this.

What If I Currently Have an ARM?

If you are currently in an ARM and you feel that it is not the best fit for you, you are by no means obligated to be stuck in a mortgage that you’re unhappy with. If you feel yourself wanting a mortgage that will give you a sense of security, you could refinance into a fixed rate mortgage. Although the interest rate for a fixed rate mortgage is a little bit higher than the fixed interest rate during the initial period of an ARM, it could be worth it to eliminate the feeling of not knowing how much your new monthly mortgage payment will be when the interest rate adjusts.