Adjustable Rate Mortgage (ARM) vs Fixed Rate Mortgage (FRM) Contrasts in Mortgage Financing

 

Adjustable Rate Mortgage (ARM) vs Fixed Rate Mortgage (FRM) Contrasts in Mortgage Financing

September 04, 2014

Various factors enter a borrower’s decision-making process when it becomes necessary to obtain an ARM (Adjustable Rate Mortgage) or a FRM (Fixed Rate Mortgage) to finance a home purchase or refinance an existing mortgage; and on some occasions, not all factors are known to the decision maker until s/he is in the presence of a bank or mortgage lender representative. However, in most cases a mortgage borrower can obtain basic information about the two contrasting mortgage descriptions and the appropriate use of each.

Among the basic information a mortgage borrower might gather about the two descriptions are their meaning, costs associated with each, appropriate or best use and term as wellas availability. So the first question which must be answered is, what is the meaning of adjustable rate mortgage? And the answer to this question is: A mortgage loan on which the interest rate does not remain constant, but fluctuates or “adjusts” periodically (every 6 months, annually, or every 2, 3, 5 or years) despite the term on which monthly repayments are amortized, is known as an adjustable rate mortgage or ARM.

Conversely, a mortgage loan on which the interest rate does remain constant for the entire term on which repayments are amortized is known as a fixed rate mortgage or FRM. Although there are fewer similarities than differences between the fixed rate and adjustable rate mortgages, features that can be considered similar are:

The term on which payments are based (15 years, 20 years, 30 years, etc.); rate is determined by an index, normally the yield on a US Treasury Note/T-bill or other such debt obligations and securities (example, 6-Month LIBOR, 1-yr T-bill, 3-yr T-bill, COFI, etc.), with the exception that rates on 30-yr FRMs are determined by the 10-yr T-bill; APR (Annual Percentage Rate), which is sometimes referred to as, Effective Annual Percentage Rate on both FRMs and ARMs as long as costs are associated with the borrowing.

Traditionally, the fixed rate mortgage was the more popular of the two because of its availability, but ARMs gained popularity in the late 1970s and early 1980s when interest rates reached historical highs and the prime rate, which was a leading indicator of mortgage rates during that period, rose to a new high of 20 percent in April 1980. In a market where mortgage interest rates climbed to double-digit figures, the adjustable rate mortgage which featured a lower initial/start rate took hold and remained a viable alternative since then.

However, the low “start rate” is only one feature of the ARM so it must also be said about this type of mortgage that it entailed at one time a number of other elements – a few still persist today – which included:

A graduated payment feature (once known as GPM or Graduated Payment Mortgage); negative amortization – a feature that is practically extinct today – which resulted in a higher mortgage balance after several years of applied payments; rate change caps (1 percent annually for 1-yr ARMs, 5 percent lifetime or the entire loan term) that places a cap above which any adjusted increase cannot go; and the variey of ARMs that gained popularity during the sub-prime era (2-28 ARM, 3-27 ARM, etc.) on which lower payments were fixed for a short period (the first 2 or 3 years) but the rate on which those payments were based still fluctuated upwards, thereby resulting in “payment shock,” causing numerous mortgage foreclosures and the eventual mortgage crises of last decade.

While the stated reliability of FRMs is an easily understood motivation of home buyers and refinancing homeowners who prefer payment stability, the reasons many home buyers opt for ARMs could be several and varied. For example, a home buyer whose income is less than that which is required to qualify for the higher-rate FRM might consider an ARM because s/he anticipates, or is promised, a promotion and along with it, increased earnings sufficient enough to cover either an expected higher payment on the ARM after rate adjustment, or a conversion from ARM to FRM based on the increased income.

Some home buyers even try to determine the length of time they expect to live in their new homes in an effort to avail themselves of the savings a lower rate ARM – in this case a 5-yr or 7-yr ARM which carries the same rate and payment for the respective periods – would generate; and if they calculate a considerable sum in reduced costs (savings) over the period, they would obtain the ARM with the intentions of selling, or refinancing into a fixed rate mortgage, after the expiration of that period.

Another scenario under which multi-unit property buyers or refinancing property owners might opt for an ARM instead of a FRM is to maximize profits from rental income they receive from those properties which, when combined with the tax-deductible benefit from mortgage interest and tax deductions for repairs and renovations to rental properties, can result in substantial profits for the owner. So there are many reasons mortgage borrowers might consider an ARM over a FRM, but as for the differences that exists between these two mortgage variations, the CFPB (Consumer Financial Protection Bureau) might have put it best with this simple comparison:

With a fixed rate mortgage, the interest rate is set when you take out the loan and will not change.

With an adjustable rate mortgage (ARM), the interest rate may go up or down. Many ARMs will start at a lower interest rate than fixed rate mortgages. This initial rate may stay the same for months or years. When this introductory period is over, your interest rate will change and the amount of your payment will likely go up.