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Fixed Rate vs. Adjustable Rate Mortgages (ARM)

mortgage fundamentals
Fixed Rate vs. Adjustable Rate Mortgages (ARM)

What is a Fixed Rate Mortgage?

A Fixed Interest Rate is an interest rate that will remain at a predetermined rate for the entire term of the loan, no matter what market interest rates do. This means that payments remain the same over the term of the loan.

What is an Adjustable Rate Mortgage?

An Adjustable Rate Mortgage (ARM) is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan.

Fixed VS ARM

FIXED ARM
Predictability
  • Rate will not change
  • Stable monthly payment
Unpredictable
  • The rate will adjust after the set period
  • Monthly payment may increase or decrease
Higher Monthly Payments
  • Initial higher rate
  • Market rate/credit-based pricing
Lower Initial Monthly Payment
  • Initial lower rate
  • Tied to index
Easier to Understand
  • No additional terms to know
More Complex
  • Need to understand terms like rate caps, margin, index, etc
Maintain Optionality
  • Keep current rate if rates increase
  • Refinance if rates decrease

General Calculation of ARM

ARM adjustments are calculated by adding the margin to the index. The margin is determined at the closing of the mortgage and does not change. The index is determined by the market and will fluctuate. The index is a published rate that is not controlled by the lender; the lender will use this as the base for establishing a new interest rate. An example of this calculation could look like this:

Fully Indexed Rate
Margin 2.75%
+ Index 0.050%
Fully Indexed Rate 2.8%

Adjustment caps, floor rates, and ceilings must also be taken into consideration. Adjustments caps are a limit of how much the interest rate can change at each adjustment. A floor rate is the lowest interest rate that can be charged during the term of the loan, whereas a ceiling is the highest interest rate the can be charged during the term of the loan.

Benefits of an ARM

An ARM may not be right for everyone, but there are definitely lots of benefits. ARMs may be right for you if you are:

  • Looking for an initial interest rate lower than a fixed rate mortgage

  • Need a short-term boost to your finances

  • Looking to save money initially

  • Intend to remain in their home for a short period of time

  • Have a potential for higher earnings in the future

Still have questions?

Find our most frequently asked questions here.

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