ARM and Fixed Rate Mortgage - Which is Better?

Q. ARM (adjustable rate mortgage) and Fixed Rate mortgage, which is better?

A. The answer depends on your specific situation, with a few important factors to consider:

1. How long will you stay in the property?
2. What are the rate and term of the fixed rate conventional loan?
3. What are the initial rates of the ARM, what is the adjustment period, how much is the index and margin of ARM?

An Adjustable Rate Mortgage 101

What is ARM?
An ARM is a loan with an interest rate that changes. It typically has a low APR to start with, which will result in lower monthly payments compared with conventional fixed rate loans with the same terms. However, the ARM's interest rate may change after a preset initial period, most likely going up which could result in substantially higher mortgage payments at that time. In addition, it is important to note that many ARM have pre-payment penalties, which means that paying them off early can result in high fees.

Initial Interest Rate
What makes ARM appealing to some people is its low initial interest rate. This low rate period may be between one month and up to ten years. At the time of the initial rate expiring, the interest rate may rise depends on what's pre-set in the loan clauses. The amount of change will range from as low as 0.05 percent to 2 percent or even more.

Two types of ARM
Fully Amortizing ARM
This is the most common type of ARM. The monthly payment is calculated to payoff the entire mortgage balance at the end of the term. The term is typically 30 years. After any fixed interest rate period has passed, the interest rate and payment adjusts at the frequency specified. A Fully Amortizing ARM will also have a maximum rate that it will not exceed. Below is a list of the most common types of Fully Amortizing ARMs.

• 10/1 ARM. Fixed for 120 months, adjusts annually for the remaining term of the loan.
• 7/1 ARM. Fixed for 84 months, adjusts annually for the remaining term of the loan.
• 5/1 ARM. Fixed for 60 months, adjusts annually for the remaining term of the loan.
• 3/1 ARM. Fixed for 36 months, adjusts annually for the remaining term of the loan.

Interest Only ARM
An Interest Only ARM only requires monthly interest payments. Since you are not paying any principal,  this can lower your monthly payment. However, since your mortgage's principal balance is not decreased, you will have a balloon payment at the end of the mortgage's term. Like a Fully Amortizing ARM, an Interest Only ARM will often have a period where the interest rate is fixed, and then it is adjusted annually. An Interest Only ARM will also have a maximum interest rate that it will not exceed. 

When to Use ARM
Homeowners need to protect themselves from ARM pitfalls. Some lenders use deceptive tactics to lure in potential mortgage applicants with falsely low interest rates or unexplained terms. It is important for ARM buyers to realize that ARM rate may adjust significantly, resulting in a much higher monthly payment. Read all terms of the ARM before agreeing to them.  

However, there are a few situations ARM might be beneficial to a homeowner :

• If you only plan to live in the property in a short period of time (less than the ARM adjustment period)
• If you cannot afford the conventional loan now but do expect future income to rise or property value to rise, and really want to have the property.
• If you have a much better investment alternative so you can get an ARM with lower payment, and put the extra money that you will otherwise put in a conventional loan into that better investment alternative.

How to Compare ARM and Fixed Rate Loan
Because ARM's rate will reset after the initial period, but we don't know what that rate will be, it's really hard to directly compare an ARM with a fixed rate loan.

However, you could use our ARM payment scenario calculator to see what will happen to your ARM loan payments with different rates in the future and if you are ready for any potential payment shock.

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