What’s best for me – an ARM or Fixed?

This question has puzzled many people when they go to purchase or refinance a home: “Should I get a low adjustable-rate mortgage (ARM), or go with the security of a fixed?” While it is true that a fixed-rate mortgage (FRM) can provide more security, it is also true that an ARM can provide more immediate savings with a lower rate and payment. There are a few things that you need to understand and questions that you need to answer before you decide on one over the other.

An adjustable-rate mortgage will almost always start with a very low introductory rate. This introductory rate is typically fixed for 2, 3, 5, 7, or 10 years; within that period, neither the rate nor payment will increase. After the fixed period is up, the rate may or may not increase. These mortgage rates are tied to certain indexes. The common indexes used for ARM rates include the monthly treasury average (MTA), the 11th District Cost of Funds index (COFI), and the London Interbank Offered Rate (LIBOR). If the index is down substantially from when you initially financed your home, your rate may decrease.

The way that the mortgage rate is determined is by taking the index that is tied to your mortgage (this should be available in your loan note) and adding a margin (the margin should also be disclosed in your loan note).

Let’s look at an example:
Let’s say your mortgage is based on the COFI, and carries a margin of 2.75. When you originally financed your home, you got an ARM with a rate of 4.5% fixed for 3 years. Three years later, the rate can now adjust, and COFI is at 5.25%. Your new interest rate is going to be 5.25% (index) + 2.75 (margin) = 8%.

There are maximum amounts by which your rate can adjust within the first year, each year thereafter, and over the life of the loan. Rates cannot typically adjust to more than 12%, so when people say that their rate is going to adjust “through the roof”, they are not quite right. Now some of you may be sitting there thinking that 12% is through the roof. Well, keep in mind, that in 1981 fixed rates were near 20%!

Fixed-rate mortgages are pretty well understood by the population; neither the interest rate nor the payment on these mortgages can ever adjust. A FRM will usually have a little bit higher interest rate than its ARM counterpart, but it offers the security of knowing you’re always going to be paying the same.

Now that you understand the details of the ARM and FRM, you need to ask yourself some questions to help you determine which is right for you. One question to ask is, “How long do I plan on staying in my home?” If you are going to live in your house forever, you may want to opt for a FRM. If, however, you are going to be selling your house and moving within the next 5 years, you may want to look at a 5 year ARM. You will have lower payments and interest charges, while not having to worry about your rate adjusting (remember it’s fixed for a certain period of time).

Another question you may want to think about is, “What is the economy going to do in the next few years?” If a recession is predicted, an ARM might be advised. This is a bit more of a gamble, because the rates may go up. However if a recession does occur, rates could very well go down.

In order to truly determine what the best program for your individual scenario is, you should discuss your options with an honest and ethical mortgage professional. Be sure you find a professional that is willing to tell you not to do the loan if it is not in your best interest; there are many that will just do a loan for their own benefit.

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Andrew Sieveke is an experienced and successful mortgage professional. To gain more insight into the mortgage industry, and make yourself a more educated borrower, please visit www.competingloans.net.

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