ARM vs Fixed Rate Mortgage FAQ’s
What are the major benefits of a Fixed Rate Mortgage?
Stability: There is no change in monthly principal and interest payments regardless of fluctuations in interest rates. Since you know what your payment will be for the life of the loan, you can budget easier and know that there is no possibility of an interest rate change making your mortgage payment unaffordable.
Security: Rates and payments remain constant. There won’t be any surprises or anxiety even if inflation surges out of control and mortgage rates head to 20 percent. As such fixed rate mortgages give you peace-of-mind.
Simplicity: Fixed Rate Loans are more straightforward and easier to understand than Adjustable Rate Mortgages.
What are the major disadvantages of an ARM?
Instability: Rates and payments can rise significantly over the life of the loan. What’s more, the first adjustment can be substantial because some annual caps don’t apply to the initial change. Also, a borrower’s initial low rate will adjust to a level higher than the going fixed rate level in almost every case even if rates in the economy as a whole don’t change. That’s because ARMs have initial fixed rates that are set artificially low. ARMs prevent borrowers from accurately forecasting and establishing long-term budgets.
Lack of Security: Rates and payments can rise significantly over the life of the loan. The many different components of an ARM and their close link to the economy make it very difficult to forecast a borrower’s future payments. Many times, the increased interest rates result in payment shock, a decreased standard of living or mortgage payment that the borrower cannot afford.
Complexity: ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused.
What is a Fixed Rate Mortgage?
A fixed rate mortgage is a mortgage in which the interest rate and the principal payments do not change during the entire term of the loan. The most common mortgage terms are 15 and 30 years.
What is an ARM?
An ARM is an Adjustable Rate Mortgage. It is a mortgage in which the interest rate is adjusted periodically based on a pre-selected index. The Fully Amortizing ARM is the most common type of ARM. The monthly payment is calculated to payoff the entire mortgage balance at the end of the term. The term is typically 30 years. After any fixed interest rate period has passed, the interest rate and payment adjusts annually. A Fully Amortizing ARM will also have a maximum rate that it will not exceed. Components of an ARM include and Index, Margin, Adjustment Period, Adjustment Cap and Lifetime Cap.
Below is a list of the most common types of Fully Amortizing ARMs.
| Common Adjustable Rate Mortgages | |
| ARM Type | Months Fixed |
| 10/1 ARM | Fixed for 120 months, adjusts annually for the remaining term of the loan. |
| 7/1 ARM | Fixed for 84 months, adjusts annually for the remaining term of the loan. |
| 5/1 ARM | Fixed for 60 months, adjusts annually for the remaining term of the loan. |
| 3/1 ARM | Fixed for 36 months, adjusts annually for the remaining term of the loan. |
| 1 year ARM | Fixed for 12 months, adjusts annually for the remaining term of the loan. |
What is an Interest Only ARM?
An Interest Only ARM only requires monthly interest payments. Since you are not paying any principal you typically have a lower monthly payment. However, since your mortgage’s principal balance is not decreased, you may have a balloon payment at the end of the mortgage’s term. Like a Fully Amortizing ARM, an Interest Only ARM will often have a period where the interest rate is fixed, and then it is adjusted annually. An Interest Only ARM will also have a maximum interest rate that it will not exceed.
What is a Hybrid ARM?
A Hybrid ARM unlike a true ARM that adjusts for the same periods for the life of the loan is fixed for a set starting period. After the starting period the interest rate adjusts for the same period for the remaining life of the loan.
What is an Option ARM?
An Option ARM is an adjustable rate mortgage with added flexibility of making one of several possible payments on your mortgage every month, in order to better manage your monthly cash flow. The most typical payment options start with the minimum payment option in which your monthly payment is set for 12 months at your initial interest rate. After that, the payment changes annually, and a payment cap limits how much it can increase or decrease each year. If the minimum monthly payment is not sufficient to pay the monthly interest due it results in negative amortization. The options also include an interest-only payment, a fully amortized payment based on a 30-year loan and a fully amortized payment based on a 15-year payment.
What is Negative Amortization?
Negative amortization is an amortization method in which the borrower pays back less than the full amount of interest owed to the lender each month. The shorted amount is then added to the total amount owed to the lender. Negative amortization is also referred to as deferred interest. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. Negative amortization loans today are mostly ARMs and many have a graduated payment option. This option offers a set monthly payment at the initial interest rate. After that, the payment changes annually, and a payment cap limits how much it can increase or decrease each year. This typically results in negative amortization. Since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.
What is an Index?
An index is a published interest rate against which lenders measure the difference between the current interest rate on an adjustable rate mortgage and that earned by other investments. It is used to adjust the interest rate on an adjustable mortgage up or down.
Common indexes used to establish ARMs include:
What is a Margin?
A margin is the amount a lender adds to the index on an adjustable rate mortgage to establish the adjusted interest rate. The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest the borrower pays. The margin added to the index is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is 8.00%.
What is an Adjustment Period?
The adjustment period is the number of months between each rate adjustment after the 1st adjustment.
What is an Adjustment Cap?
An adjustment cap is the maximum percentage that the rate will increase for each subsequent adjustment periods after the first adjustment.
What is a Lifetime Cap?
A lifetime cap is the maximum percentage that the note rate can rise to.
