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Choosing Between a Fixed Rate Mortgage and Adjustable Rate Mortgage

Choosing Between a Fixed Rate Mortgage and Adjustable Rate Mortgage

Prior to the 1980's, most home loans were for 30 years at a fixed mortgage rate. Here are two of the most likely and popular financing options facing consumers today.

Fixed Rate Mortgages

Today, fixed rate home loans can usually be obtained for 10 to 30 years - sometimes as long as 40 years. The total amount of interest and principal payment remains the same each month.

In addition to interest and repayment of principal, the monthly payment will typically include a smaller amount, which is contributed to an escrow account for payment of real estate taxes and insurance, if applicable. Taxes will most likely increase over the years. Thus, a fixed rate mortgage provides the homeowner the peace of mind that the largest component of the monthly mortgage payment, principal and interest, will remain fixed and constant for the life of the loan.

Adjustable Rate Mortgages

During the 1980’s and 1990’s and early 2000's, adjustable or variable rate mortgages became increasingly popular. With adjustable rate mortgages,or ARM's as they are sometimes called, the interest rate can adjust (or change) at specific times during the life of the loan.

Many adjustable rate mortgages begin with an interest rate that is often lower than those of a fixed rate mortgage. This means that after the first year, the interest rate will probably increase. Adjustable rate mortgages usually change once a year, depending on the agreed upon initial adjustment period. The adjustable rates are tied to a national index rate which measures the cost of borrowing money, most often the current rate for United States Treasury Bills.

What About Caps?

A cap is simply the limit that mortgage rates can increase over the life of the lmortgage. It is always in the best interest of the consumer to have a cap on any adjustable rate mortgage. Often there is both a yearly cap and an overall cap on the mortgage rate for the life of the loan. When considering an adjustable rate mortgage, it is very important to consider the possibility that the interest rate might increase

When applying for a mortgage, you should always ask your loan officer what index rate the loan is tied to; how often it changes, and where you can find information of that particular index.

The adjustable interest rate actually has two main parts-- an index rate and a “margin.” For instance, say your adjustable rate is tied to a Treasury Bill index. If that index rate is 6.2 percent, and your mortgage has a margin of two percent, your total mortgage rate is 8.2 percent, the combination of the two. The margin, usually several percentage points, is the amount the lender adds to the index rate. So, when applying for an adjustable rate loan, you should always inquire as to both the index rate and the margin.

Fixed Rate or Adjustable: Making the Right Choice

The advantage of a fixed rate mortgage is that it provides the purchaser with a definite amount that must be paid with each monthly installement. Some individuals prefer the piece of mind that this option offers. It may be easier to plan household budgets around its definite payment schedule. You should consider how long you plan on staying in the property as one of the most important aspects of your home financing decision.

A fixed rate mortgage also offers less flexibility, particularly if interest rates decline. An adjustable rate mortgage can be of real benefit to a homeowner during periods of declining interest rates.

Because adjustable rate mortgages often have lower intial rates than fixed rate mortgages, a home-owner may experience savings in the first few years of the mortgage. As a result, many homeowners are able to qualify for this type of mortgage because of lower initial rates. But if the ARM adjusts to a rate higher than current Fixed rates, a refinance will actually raise your monthly payment.


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