Fixed Mortgages vs. Adjustable Rate Mortgages

With a fixed-rate mortgage loan, your monthly payment of principal and interest never change for the life of your loan. Your property taxes may go up, and so might your homeowner’s insurance premium (part of your monthly payment), but with a fixed-rate loan, your payment will be very stable. Fixed-rate loans are available as 30-year, 20-year, 15-year even 10-year loans. During the early amortization period of a fixed-rate loan, a large percentage of your monthly payment goes toward interest, and a much smaller part toward principal. That gradually reverses itself as the loan ages.  You might choose a fixed-rate loan if you want to lock in a low rate.

If you have an Adjustable Rate Mortgage (ARM) now, refinancing with a fixed-rate loan can give you more payment stability. Generally, ARMs determine what you must pay based on an outside index that adjusts every 6 months or once a year (i.e. 6-month Certificate of Deposit [CD] rate, one-year Treasury Security rate, the Federal Home Loan Bank’s 11th District Cost of Funds Index [COFI], or others).

Most programs have a monthly payment “cap” to keep payments from going up too much at once, or a cap on how your interest rate can jump in one period (such as, no more than two percent per year, even if the underlying index goes up by more than two percent). Almost all ARM programs have a “lifetime cap” — your interest rate can never exceed that cap amount, no matter what.

ARMs often have their lowest, most attractive rates at the beginning of the loan and guarantee that rate for anywhere from a month to ten years. You may hear people talking about or read about what are called “3/1 ARMs” or “5/1 ARMs,” meaning the introductory rate is set for three or five years. Costs adjust according to an index every year thereafter for the life of the loan. These loans are best for people who anticipate moving and selling the mortgaged home within three or five years.

You might choose an ARM to take advantage of a lower introductory rate and count on either moving, refinancing again or simply absorbing the higher rate after the introductory rate goes up. With ARMS, there is a risk that your rate will go up, but you’ll enjoy when rates go down by pocketing more money each month rather than spending it on your mortgage payment.