A mortgage on your home is a long-term investment, generally lasting anywhere from 15 to 30 years. All homeowners need to decide if they want to have a fixed rate of interest on that mortgage with steady and unchanging monthly payments or dip a toe into the complex world of an adjustable rate mortgage or ARM.
Fixed-rate Mortgage
A fixed-rate mortgage charges the homebuyer an interest rate that never varies throughout the term of the loan. The monthly payment is the same every month, but the portion of each payment that goes towards the principal and interest changes, with each month paying a little less interest and a bit more principal. The amortization of your mortgage always has the bulk of the payment going towards interest initially. Over time, a greater portion of the monthly payment goes towards the principal. There is a short term loan amortization calculator to help calculate those figures. The main advantage to a fixed-rate loan is the homebuyer is protected from any interest fluctuations. Your mortgage is locked in to a certain interest rate no matter what the market is doing. Fixed-rate mortgages are easy to understand and are quite popular. They vary little from bank to bank. The steady monthly payments are handy for budgeting purposes, too.Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage is more complicated. At the beginning, the interest rate on an ARM is lower than the rate of a fixed-rate mortgage, but that rate changes over time. ARMs have an initial period where the interest rate is constant followed by adjustments to the interest rate at predetermined times. This is often referred to as a floating rate because it fluctuates according to the market. ARMs come in many varieties. They are designated by two numbers. The first number represents the initial time period the loan is at a fixed rate. The second number represents the time period for each adjustment. For example, a 5/1 ARM features a fixed rate for five years, followed by a variable rate that adjusts every year. A 5/3 ARM starts with a fixed rate for five years and then adjusts every three years. The floating interest rate is based on an index determined by the going market rate plus an additional spread called an ARM margin. The rate can increase or decrease. Once you have passed your initial fixed period, the adjustment takes place and stays in place for that set time period before the next adjustment is set to occur.Index
Generally, mortgages are tied to one of three indexes: the maturity yield on one-year Treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate. Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time the interest rate adjusts, the rate falls to 4%, based on the loan’s 2% margin. Often an ARM has a rate cap or ceiling, meaning that it can never increase beyond a predetermined interest rate or percentage change. A ceiling is for the entire term of the loan while rate caps are just periodic limits on how much the interest rate can change for each period or on the monthly payment. An ARM can be a great choice for homeowners that plan to move within a few years or who plan to pay off their mortgage quickly. Another reason some homebuyers choose an ARM is that the initial fixed-rate period can have attractively lower interest rates, especially if the initial period is quite short. Some homebuyers take advantage of the initial low interest rates of an ARM with the plan to refinance when the time for a rate change approaches. Talk to Spire Financial to see if an ARM is a better choice for you than a fixed-rate mortgage.Latest Articles
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