Fixed vs. Adjustable Rate Mortgages
Most homebuyers are tempted to go for the traditional, 30-year fixed home loan—but that’s not the only option. As interest rates inch higher, potential home buyers may find that an adjustable rate mortgage may come with a lower initial rate. What’s the difference between the two?
The Fixed-Rate Mortgage
A fixed-rate mortgage means you’ll be paying the same interest rate for the entirety of the loan. Almost all fixed-rate mortgages come along with an amortization schedule: That means you’ll be paying both interest and principle together as you pay off debt on the loan at regular intervals (like a monthly payment).
There are non-amortized fixed-rate mortgages available, but they aren’t very common. A non-amortized fixed-rate mortgage means that while you’ll make regular payments for interest only, you only pay toward the principle when a lump sum is required. Non-amortized fixed-rate mortgages come with higher interest rates in part because this type of loan reduces cash flow to the lender.
The Adjustable Rate Mortgage
An adjustable rate mortgage, often abbreviated as ARM, is exactly what it sounds like. Unlike a fixed-rate mortgage, an adjustable rate mortgage means the interest rate will fluctuate over the lifespan of the loan. Still, it has elements of a fixed-rate mortgage, which is why it’s also known as a hybrid mortgage: adjustable rate mortgages start off with a set rate (just like a fixed mortgage) for an introductory period. The length of that introductory period can vary, but it’s most commonly five years with three-, seven- and even 10-year introductory periods available as well.
After the introductory period, the lender is eligible to adjust your rates every year thereafter. In lender-speak, this is known as a 5/1 ARM (or a 3/1, 7/1, or 10/1 depending on the length of the introductory period). Adjustable rate mortgages in their introductory period usually feature rates that are lower than fixed-rate mortgages.
How do lenders calculate adjustable rates?
In an adjustable rate mortgage, once the introductory rate period is over, you’ll be subject to an adjusted rate each year. Lenders can’t just set an interest rate willy-nilly. Instead, they’ll use index rates and margins to determine an annual increase or decrease.
Wait, what are indexes and margins?
To understand indexes and margins, we’ve got to back up and talk about the stock market a little bit.
As BankRate describes, indexes are samplings of the stock market that give a representation of the larger picture. Investors use indexes to gain an understanding of the stock market and where it’s headed. Your loan paperwork will tell you which index your mortgage is tied to, but common indexes for adjustable rate mortgages include Treasury yields set by the federal reserve and the 11th District Cost of Funds Index, known as COFI, which tracks the interest financial institutions are paying in California, Arizona, and Nevada.
Basically, your lender will get a sense of the larger market to determine a rate. That’s the index. Then, they tack on the margin. While indexes can fluctuate, margins cannot. Your interest rate will never match the index, because when your lender sets an adjustable rate mortgage for you, they’ll also set a margin of a certain amount of percentage points after your introductory period is up.
For example, let’s say your lender uses a monitoring index with rates of 1.75 percent, and your margin is set at 3 percentage points. Your adjusted interest rate for the year would 4.75 percent. The next year, perhaps the index drops a bit and shows rates of 1.25 percent. When you tack on the 3-percentage-point margin, your rate for that year will be 4.25 percent. Remember, these are just examples. Your ARM will depend on the length of your introductory period, the index tied to your loan, and the margin.
Is an adjustable rate mortgage risky?
Fortunately, there are caps on adjustable rate mortgages, so you won’t see your rate skyrocket year over year. Adjustable rate mortgages also include lifetime rate caps. You can read more about ARM caps here.
ARMs also mean if rates fall, you won’t have to worry about refinancing to take advantage of a lower rate: You’ll get it automatically through your adjustable rate, leaving those fixed-raters contemplating whether or not they should refinance. Still, adjustable rate mortgages are inherently uncertain. While you’ll receive lower rates early on, even with caps, rates can still rise significantly depending on year to year indexes.
How do I know which type of rate is right for me?
You may want to consider factors like how much you’ll save initially with an adjustable rate mortgage as well as how long you’re planning on staying in a home. If you only anticipate staying in a home for five years or less, an ARM may be attractive since you’ll receive a lower rate for that initial five-year introductory period. If you’re viewing your home purchase as a permanent place to roost rather than a starter home or investment, you may want to opt for the fixed-rate mortgage.