A fixed rate mortgage (FRM) is one where the interest rate on the loan remains the same throughout the term of the loan, as opposed to loans where the interest rate may fluctuate according to an index. For example, if your fixed rate mortgage is 5.75%, the interest rate will be 5.75% during the entire life (usually 15 or 30 years) of your loan.
An adjustable rate mortgage (ARM) usually has a fixed interest rate for the first year of the loan and can go up or down at each annual reset. The term of an ARM could be 3, 5, 7 or 10 years and interest rate changes will vary based on economic conditions. So for example a 5/1 ARM means a 5-year loan term, with a fixed rate for the first year and annual resets each year. The amortization schedule is still usually based on a 30 year term.
Typically the interest rate of an ARM loan is much lower than a conventional fixed rate 30-year-mortgage, which makes an ARM more affordable for those whose incomes are lower now than they expect them to be in a few years. In good market conditions, an adjustable rate mortgage can be very advantageous for homeowners who expect to upgrade to a different home in less than 10 years.
There are several important features of adjustable rate mortgages:
- Initial interest rate – the beginning interest rate on an adjustable rate mortgage.
- Adjustment period – the length of time the interest rate or loan period on an ARM will remain unchanged. The rate is reset at the end of this period, which changes the monthly loan payment amount.
- Index rate – Many lenders associate ARM interest rates with changes in an index rate. The most common one is the rate on 1-year, 3-year or 5-year Treasury securities.
- Margin – the percentage points that lenders add to the index rate to determine the ARM’s actual interest rate.
- Interest rate caps – caps are limits on how much the interest rate or monthly payment can be changed at each adjustment period or duration of the loan. This can sometimes prevent payment shock, which is a term used to describe the severe upward movement of mortgage loan interest rates and its negative effect on borrowers.
- Initial discounts – sometimes interest rate concessions are used as promotional aids at the beginning of a loan. They reduce the interest rate below the prevailing rate.
- Negative amortization – this typically means the mortgage balance is going up. This can happen when the monthly payments aren’t large enough to pay all of the interest due on a mortgage. Caps can sometimes cause this “neg am” effect.
- Conversion – on certain ARMs, the lender may agree to convert the loan to a fixed rate mortgage at select designated times.
- Pre Payment – some agreements may charge fees or penalties if the ARM is paid off early. While these can sometimes be negotiated, it is always best to know what these penalties are before deciding if an ARM loan is right for you.
