Fixed Rate Mortgage vs Adjustable Rate Mortgage

The choice between a fixed rate mortgage and adjustable rate mortgage is one of the first things a borrower must consider when searching for a home loan. The choice comes down to needs and the personal preference of the borrower. We will start with a comparison of the two mortgage types and identify the strengths and weaknesses of each one.

A fixed rate mortgage offers a fixed interest rate over the entire loan term. Fixed rate mortgages allow a borrower to be certain their interest rate will not increase over time. They also ensure that their mortgage payment will not increase because of a change in the interest rate. These types of mortgages are the most common home loans you will find today. If you plan on staying in your home for a long period of time, a fixed rate mortgage might be good for you. If a strict budget is also a concern, a fixed rate mortgage will also offer you a stable payment. The only real negative about a fixed rate mortgage is that often time, people don't actually need them. Most people will move or refinance their home loan within 5 years and that is why adjustable rate mortgages deserve consideration.

An adjustable rate mortgage has a fixed period where the interest rate will not change for a specified amount of time. A 2 year, 3 year, 5 year, and 7 year adjustable rate mortgage, or ARM as they are referred to, will have a fixed interest rate for 2, 3, 5, and 7 years respectively. After the fixed period has expired, your new interest rate will be calculated by adding the index the loan is based off of and the margin set by the lender. The index is simply a number, or percentage the interest rate is derived from. The margin is a percentage specified by the lender that will be added to the index to calculate your adjusted interest rate.

Example:

An adjustable rate mortgage might be based off the 6 month LIBOR rate (London Inter Bank Offered Rate). This is essentially a percentage that banks borrower money from one another. Take a look at the breakdown that shows how the index and margin affect your adjusted rate on an adjustable rate mortgage.

Index: 3%

Margin: 4%

Index + Margin = 7%

If the Index changes, your interest rate will change. For example, let's say at the beginning of the year, the above example is true. However, 12 months later, the Index has increased. Your new rate, if your loan terms allow a subsequent adjustment (explained below) would be as follows:

Index: 3.45%

Margin: 4%

Index + Margin = 7.45%

Your new interest rate would go from 7% to 7.45% because of the change in the Index. Indexes are constantly changing and could go up or down.

Adjustable rate mortgages also have adjustment schedules and caps. If you're considering an adjustable rate mortgage, knowing the adjustment terms is imperative. A 2/2/6 adjustable rate mortgage on a 5/1 ARM (Fixed for 5 years and can adjust each year thereafter) would mean the following:

The initial adjustment could increase your rate up to 2%

The subsequent annual adjustment could increase your rate another 2%

The rate adjustment cap over the lifetime of the loan could increase over your initial interest rate on the loan by 6%

For more information on adjustable or fixed rate mortgages, speak to a BeatMyBroker.com approved mortgage professional that can answer any question you might have.