- Fixed rate mortgages are relatively simple arrangements. The lender provides a lump sum of money up front that the borrower typically pays back over 30 years, with a pre-set rate of interest included. Over the life of the loan, the principal and interest payment cannot change. For instance, a 30-year mortgage for $250,000 at 4.75 percent interest would carry a payment of $1,304.12 dollars per month, which would remain the same for 30 years.
- Adjustable rate mortgages, or ARMs, work on the same basis as a fixed rate mortgage with one key difference: the interest rate of the mortgage can fluctuate over the life of the mortgage. It can still be paid off in the same amount of time, but the principal and interest portion of the payment can change. For example, a $250,000 ARM taken out in 1982 with a maturity of 2012 could have seen its rate fluctuate from 3.5 percent all of the way up to 13 percent, giving it a range of payments from $1,122.61 to $2,765.50 per month.
- There are five factors to pay attention to when considering an ARM. The first two are its floor and ceiling rates. Most ARMs have maximum adjustments, meaning they will not fall below a minimum interest rate, called a floor, or rise above a maximum interest rate, called a ceiling. Their interest rates are computed by taking an index rate, such as the Prime Rate, 11th District Cost of Funds Rate, or LIBOR, and adding an additional margin, called a spread to that rate. For instance, a loan which is tied to the Prime Rate with a 50 basis point spread would have a rate, as of December of 2010, of 3.75 percent, based on a prime rate of 3.25 percent plus the 0.5 percent spread. The last variable is the maximum adjustment, which determines how much your loan can go up or down in a year. Loans with lower maximum adjustments will smooth out large jumps in the interest markets.
- Fixed rate mortgages are appropriate if you plan to stay in your home for a long period of time. They also make sense if taken out when interest rates are extremely low. Even though the borrower may pay more when rates are low, that additional cost is more than balanced out by eliminating the risk of interest rates going up in the future.
- ARMs make sense if you know that you will not be owning the property for a long period of time. Since many ARMs have a low fixed rate for their first five years, they can be a cheap way to get short-term financing. The other time an ARM can make sense is if the borrower is sure that their income will be going up in the future. That way, they can enjoy the benefits of a low payment in the short term, knowing that they will be able to afford a higher payment in the future. This second strategy, though, can be extremely risky.
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