Adjustable Rate vs. Fixed Rate Mortgages

Posted by Sawyer Jones on October 24 2017

When it comes to Adjustable Rate Mortgages (ARMs) vs Fixed Rate Mortgages, the main difference is whether the interest rate can go up and down (adjustable rate) or if it is locked in (fixed rate). Here’s how that difference can impact a buyer’s decision.

To Fix or Not to Fix? That is the Borrower’s Question

Fixed Rate Loan Feature: Some Payment Predictability

A fixed rate loan can offer your borrowers some amount of predictability in terms of their monthly payment. Their monthly combined principal and interest payment are set when they take out a standard fixed rate mortgage loan and do not change throughout the loan. Note though that this does not mean that the borrower’s monthly payment will stay the same. Fluctuations in tax rates and homeowner’s insurance premiums can change monthly escrow payment amounts, though the combined principal and interest will remain level.

Adjustable Rate Mortgage Feature: Low Introductory Rates

Most ARMs begin with low interest rates that are usually below the rates being offered by fixed rate mortgages, though once the introductory period has wrapped up, the interest rate on the mortgage can go up. When this rate goes up, the monthly payment for your borrower will also likely go up. The interest rate that the borrower pays is tied to a larger index of mortgage rates and when it goes up so too will their payment, though it can go down with the index as well depending on the type of ARM. Many ARMs have maximum amounts that they limit each adjustment to, with some of them also having limits on how low the interest rate can go.

adjustable rate

What Borrowers Need to Know About Adjustable Rate Mortgages

Before counseling your borrower to take out an ARM, educate them on the details of the type of ARM that they are getting into. Make sure they know the critical components of how high the interest rate and monthly payments can get per adjustment, and how often the interest rates will adjust. For instance, a 4% ARM could end up as high as 9% in just 3 years, and if this is a possibility for your borrower, they need to be made aware of that so that they can be prepared in case that comes to pass. The very first adjustment can be surprisingly large, as not all annual caps apply to the first adjustment, which could again be a nasty surprise for your borrower if they are not aware of the possibility.

Why Your Borrowers Might Consider an ARM

Some of the reasons that an ARM might work for your buyer include:

  • ARMs can offer a cheap way for borrowers to buy if they are planning on moving out in the short term.
  • ARMs can allow borrowers to get the benefits of falling rates without needing to refinance the loan, avoiding paying closing fees again.
  • This type of mortgage can allow borrowers to purchase larger homes than they otherwise could, because lower rates and payments at the start can be used to qualify the borrower for a larger loan.
  • ARMs can allow borrowers to save and invest more money, as the borrower can take the money that would be going initially to a loan with a higher monthly cost and invest in a higher yield investment.
    

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