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Adjustable Rate vs Fixed Rate Mortgage Basics

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Adjustable vs Fixed Rate MortgagesAdjustable Rate Mortgage Basics: ARM or Fixed Rate?

With an adjustable rate mortgage (ARM) you pay a fixed rate of interest on your mortgage for a specified period, after which the rate adjusts until the term of the loan is complete. The initial monthly payments will generally be lower than those with a fixed interest rate, but this type of mortgage is not suitable for everybody.

The initial rate period can be anything from one month to 10 years, although the general standard today is regarded as 5 years.  Other common arrangements are over 3, 7 and 10 years. Initially, the rate will be set at a level below than that of a fixed rate mortgage. At the end of the agreed term, the interest rate will be adjusted annually according to an index stated in the closing documents of the mortgage arrangement.

Fixed Rate Calculation

The fixed rate of an adjustable rate mortgage, known as the ‘Start Rate,’ is the minimum interest rate that applies to the sum borrowed. This ‘floor rate’ as it is known will not be reduced, even if general lending rates drop below this figure at a later date.

At the end of the ARM fixed rate period, the lender will check the ‘index rate’ and apply an interest rate to the balance of your mortgage that slightly exceeds this.  Your monthly repayments will then be increased accordingly. This is repeated each time an adjustment is required – usually annually, but this will be detailed in your initial AMR mortgage agreement.

Benefits of an Adjustable Rate Mortgage

There are several reasons for you deciding to take an ARM. They are not suitable for everybody, but if you prefer the security of knowing exactly how much your monthly repayments will be until your mortgage is paid off, then go for a fixed rate mortgage.

Some benefits of an ARM are:

a)   You may be purchasing your home with a view to selling it within the fixed rate period. For example, if you have reached the first rung of the housing ladder, you might intend to sell your home after 3-4 years for a better one. Your repayments will be less with an adjustable rate mortgage than with a fixed rate.

b)   You intend purchasing a new home within a few years of buying your first home.  Just like a) above, but perhaps you have purchased a small apartment or condo after marrying, and intend to upsize once a family comes along and you need more bedrooms.

c)    If you intend making extra payments, over and above your regular payment, then an adjustable rate mortgage will be ideal for you. Even by paying the same as you would had you taken a fixed rate mortgage, the extra payment will go towards reducing the principal rather than interest. Check on penalties for early repayment!

d)   You might intend to refinance sometime over the next 5 years or so. In this case, you enjoy the lower interest rate until you take that step. Some people do this when their credit is not as good as it might be. After two years or so your credit score might have improved enough through you maintaining your repayments on time to enable you to get a longer term fixed rate mortgage. Your home is your security for the initial fixed rate period.

Disadvantages of an ARM (Adjustable Rate Mortgage)

Obviously, lenders do not give money away, and would not offer an agreement enabling you to pay them less without them ultimately benefiting. Here are some of the aspects of this type of mortgage you should consider:  what happens after the honeymoon and your interest rate is ‘reviewed?’  Here are three problems you might have to face:

1)   During your fixed rate period the interest applied to your balance cannot drop below the agreed initial figure – even if general interest rates drop. You are tied into that fixed rate just like those that took a fixed rate mortgage (though your fixed rate will be lower than theirs).

2)   Also, once the agreed fixed period is over, that rate will be lowest and will not drop below it. If you take a mortgage during highly inflationary periods, where interest rates can be as high as 15% or more, you might be offered a fixed rate of 9% with your ARM. You are stuck with this, even if times improve and new borrowers are being offered 4%-5%.

3)   At the end of the fixed rate period, your repayments could increase significantly, putting you in financial distress.

Is An Adjustable Rate Mortgage or Fixed Rate Mortgage Right For Me?

If you are prepared to meet the significantly higher repayments you might face once the fixed rate period is over, want to repay your mortgage quickly or intend selling your home within a few years of buying it, then an AMR is likely your best choice.

However, an adjustable rate mortgage can come with complex terms and conditions, and it is critical that you fully understand what you are agreeing to.  We can help answer any questions you might have about fixed rate or adjustable rate mortgages. We can also give you an up to the minute mortgage rate quote if you call us directly or use the fast rate quote form above.

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