Americans Become More Mobile
Americans are on the move again. Instead of staying put in our homes, we are moving to new ones. On average, in the US, we move every seven years. That means looking for new home loans, and weighing the differences between fixed rate mortgages and ARM rates.
To decide which makes better financial sense, you need to know the key differences between these loans.
What Is A Fixed Rate Mortgage?
You recognize these home loans when you see them. They have a fixed term, usually 15 or 30 years, and a fixed interest rate and payment for their duration. They often feel safer, because you know what you’re paying each month.
Fixed-rate mortgages, or FRMs, are great choices for people settled in their careers, homes, and communities. They are best for people who stay in homes for 15 years or longer. If you have one, you chip away at your mortgage balance — one payment at a time until it’s paid in full.
In the past, homeowners had mortgage burning parties after paying off their 30-year mortgages.
FRMs do offer stability, but it comes at a price.
These loans are nearly impossible to customize to individual homebuyer needs. Their higher initial interest rates mean these loans cost more if you don’t stay in your home until you can burn your mortgage.
To lower your payment when rates drop, you have to refinance. That’s pretty expensive.
Qualifying for a mortgage may be more difficult with a FRM. Lower initial ARM rates help borrowers buy more house. That opens the homebuying market to more buyers.
What Is An ARM?
The Adjustable Rate Mortgage, or ARM, is just what it sounds like. It’s a home loan in which the APR adjusts periodically or is variable depending on the mortgage’s terms. Your rates can rise but they can fall, too.
In the past, these loans were pretty scary for borrowers because their rates began resetting right away — within one month to one year. Today, hybrid ARMs come with rates fixed for three, five, seven and ten years. That makes them safer.
You’ll see the “hybrid ARMs” identified as 3/1, 5/1, 7/1 and 10/1. The first number indicates how long the initial rate is fixed. The second indicates how many times per year the rate can change after the initial period.
Typically, ARMs have a much lower introductory interest rate than a fixed rate mortgage. That difference is called the “spread” between the two types. The spread between a 5/1 ARM and a 30-year FRM is typically one-half to one percent.
How Are ARM Rates Determined?
ARM rates rise or fall based on the mortgage indexes used to calculate them.
The most common ones for setting ARM rates include Constant Maturity Treasuries (CMT), London Interbank Offered Rate (LIBOR) and the Cost of Funds Index (COFI).
Lenders take the loan’s index and add a percentage to that, a margin, to calculate your ARM rate. The result is called the “fully-indexed” rate.
ARMs behave according to their index and terms. As of this writing, for example, you might find a LIBOR ARM with a 2.0 percent margin. With the index at 1.74 percent, if the loan were adjusting today, the new rate would be 3.74 percent.
You might also be offered a CMT ARM with a 2.5 percent margin. Today’s CTM index is .83 percent, and the loan’s fully-indexed rate today would be 3.33 percent.
It’s important to not just compare your starting rate, but what could happen to your loan in the future when you shop for a mortgage.
Choose The Right Caps For Your ARMs
Periodic caps limit how much your ARM rate can adjust up or down each year. Typically, rate increases are limited to no more than two percent per year.
However, that limit might be higher for the first increase. For a 5/1 ARM, the first reset does not occur for five years. That first adjustment is typically limited to three percent.
A lifetime cap restricts how high the loan’s interest rate can go over the loan’s duration. Commonly, the lifetime cap is six percent higher than the start rate.
if you think you might keep your loan over the long-term, caps become very important.
When Is An ARM Better Than A FRM?
The best mortgage for you depends on what your plans are when you buy. Maybe you’re not settled in your career, need to move when you have kids, or change districts when they start school.
In those cases, making lower mortgage payments is ideal. You can save money for your next move that way.
If you’re like most people today, you won’t stay in your home more than seven years. That probably makes a 5/1 or 7/1 ARM right for you.
When you can avoid it, don’t invest in a fixed rate loan for a starter home or short-term investment. You’ll end up with less house and a higher mortgage payment.
If you know you’re staying in your home more than ten years, a fixed rate mortgage is for you. When you want a lower interest rate on that loan, ARMs are great for refinancing.
Adapt ARM Loans To Your Needs
No matter what your plans are, you probably can find the right ARM for your needs. There’s much flexibility in them.
Along with the standard ARM types, you can find 5/5, 15/15 and other hybrid variable rate loans in your market.
With any ARM, you can refinance into a new one or a fixed rate loan at the end of that introductory rate period.
Know Your Borrowing Needs Up Front
ARM loans are safer than ever, but only if you know what you’re doing. Before you choose, do your math. Decide how long you’re going to stay in the home.
Calculate how much you can afford to see your ARM rate increase when your loan rate becomes variable.
That way, you’ll know which ARM to choose and have a plan for when your rate shifts.
What Are Today’s Mortgage Rates?
Current mortgage rates for ARMs run significantly lower than those of fixed mortgages. You’ll want to compare both the loan’s start rate and fully-indexed rate when you shop for an ARM.