Buying a home or even just refinancing your current home can be an overwhelming task. Along with gathering all of your financial data, there are many options in home financing to choose from. We will examine the differences between the adjustable rate mortgage (ARM) and a fixed rate home loan.
ARM LoanThese loans generally offer lower rates in the beginning to help offset the risk you assume in the future when interest rates change.
An ARM loan is perhaps one of the most difficult financing options to understand. With an ARM loan, the interest rate changes over the life of the loan causing your mortgage payment to fluctuate.
To begin to understand ARM loans, there are a few key terms you must be familiar with:
Adjustment period: This is the period between rate changes. On a one-year ARM, the adjustment period is once a year meaning the most often the interest rate is subject to change is once a year.
Index used & current rate: The changes in the interest rate of an ARM loan are tied to an index rate. Many lenders use the Treasury Bill rates or their own cost of funds. It is important to know which index your lender is using and where the index rate is published.
Margin: This is the percentage points your lender adds to the index rate. For instance, if the index rate is 5% and your lender's margin is 2%, then the interest rate on your ARM loan will be 7%. The margin is generally set for the life of the loan.
Interest rate caps: Interest rate caps are available on most ARM loans. These caps can prevent wild adjustments in your interest rate and ultimately your monthly payment. There are two types of caps - periodic and overall or lifetime.
The periodic cap sets a limit that the interest rate can increase for each adjustment period. It is common for the periodic cap to be set at 2%. If on your first adjustment, the index had increased by 3% but you have a 2% periodic cap, your rate will only increase by 2%. However, let's assume in the 2nd year of the loan, the index rate remained the same. When your adjustment is due again, it will increase by 1% (to be equal the current rates), even though the index remained unchanged over the past year.
The second type of cap is an overall or lifetime cap. This cap sets a maximum for your interest rate over the life of the loan. If your interest rate was set at 7% and your overall cap is set at 5%, then the maximum your interest rate will be is 12%. Even if the index rate climbs to 15%, you will never pay more than 12% on your loan. However, keep in mind that a 5% change in interest rates can have an enormous effect on your payment.
Payment caps: Some ARM loans utilize payment caps. Rather than limiting the interest rate, this sets a maximum your payment can increase in each adjustment period. Payment caps are generally based on percentages. If your payment cap is 5% and your house payment is $1,000, the maximum your payment could increase to is $1,050 in the first adjustment period. On the second adjustment, it could increase an additional 5% to $1,102.50 and so forth. The downside to this cap is that your interest rate does not change. The amount you owe could be increasing at a faster rate than your payments. This can lead to negative amortization.
Negative amortization: This is when your monthly payment does not cover the interest on the loan. When this happens, unpaid interest is added back to the principal portion of your loan and accrues interest again. Ultimately, this can result in owing more on your loan than you originally borrowed. Some lenders will set a limit to negative amortization at 125% of the loan amount. In this example, on a $100,000 loan, your loan balance would not exceed $125,000. However, when it reaches that amount, the lender will likely adjust your payments higher so the loan will still be paid to zero at the end of the term.
Convertibility or prepayment privileges: Convertibility means that at certain pre-set times, you have the option to convert your ARM loan to a fixed rate loan. The loan is generally converted at market fixed rates. There is usually a fee at the time of conversion as well as additional fees at the inception of the ARM loan. You should also be aware of prepayment privileges for your ARM loan. While most lenders will not access a penalty for prepayment, some lenders can charge a fee if you prepay your loan. This is usually a negotiable feature at the inception of the loan.
Fixed Rate Home Loan
For those of you who want a set payment and no risk, a fixed rate home loan may be the option for you. With fixed rate home loans, the lender sets your interest rate at the inception of the loan and it never changes. This means your payment will remain the same over the life of the loan no matter what is happening in the economy or with the index rates that ARM loans are tied to.
The main disadvantage with a fixed rate loan is when interest rates drop below your current interest rate. When this happens, you have the option to refinance, but you must pay closing costs again as well as gathering and filling out all of the paperwork that is required for a mortgage. For those with an ARM loan, they just sit back and enjoy a lower payment with no refinancing haggles. However, when interest rates rise, you will be the one sitting back relaxed with a fixed payment while those with an ARM loan figure out a way to absorb the increase in their house payment.
Ask Yourself This Question
Ultimately, the decision is yours to make. When considering your options, one of the deciding factors should be how long you plan to own your home. If you know it will be short term, an ARM loan may make more sense as interest rates will not have as much time to fluctuate. If you are looking at this home as the place for retirement, locking in a low fixed rate now with a set payment may be the solution for you.
Over the past few years, with mortgage rates at an all time low, many experts feel it is the time to lock-in a fixed rate loan for the long term. But when interest rates rise for fixed rate loans, an ARM may also be a more affordable road to home ownership, regardless of how long you plan to own your home. As long as you have a convertibility clause, you can convert to a fixed rate when interest rates drop again.