Fixed loan type vs adjustable: higher rate vs uncertainty

A few decades ago, the home buyer could only get the only type of loan: fixed-rate 30-year mortgage. Now the borrower can choose between the rate that is fixed for the life of the loan (fixed-rate mortgage or FRM) and a rate that fluctuates in line with major indexes (adjustable-rate mortgage or ARM). Both have their advantages and disadvantages.

Statistics show that approximately 30% of all mortgages now being made have some form of adjustable rate feature.

The reasons to choose ARMs are:

ARMs offer lower rates and payments early on in the loan term.
ARMs allow borrowers to save and invest more money if they use initial savings on lower ARM payments in higher-yielding investments.
They also tend to offer more liberal qualifying terms. First, because they are not structured for re-sale to investors and are more flexible and easy to customize to suit individual needs. The second reason is that lenders use the lower payment when qualifying borrowers, so they can qualify for a larger loan.

The disadvantages of the ARMs are:

Offering low rates early in the term, they hold a potential risk for sharp rises later if the underlying rate fluctuates upward. Due to artificially low initial rate, it will almost certainly adjust to a level higher than the current fixed-rate level even in case of stable rates.
ARMs are more complicated for the consumer.
They can lead borrowers to owing more money than they did at closing, if the low payments do not cover all of the interest due and the rest is rolled into the principal balance. This occurs primarily when you have a payment cap on your ARM limiting your monthly payment.

Lenders have tried to address these drawbacks by adding more features to ARMs. To protect the borrower against extreme rate fluctuations, lenders supply ARMs with annual (or periodic) caps that represent the maximum number of points the rate can rise within one year and lifetime caps that are the limit to rate rise over the life of the loan. However, even a lifetime cap of 6% combined with a 6% initial rate allows the rate to skyrocket to 12%. Keep in mind that some annual caps do not apply to initial change. Remember that caps work also for downward adjustments.

The starting rate for ARMs is usually a few points down from the “index+margin” formula; it is a “teaser rate” that is supposed to trap you into taking the loan. “Teaser” ARMs can even have a starting rate that is lower than the value of the underlying index, though this is admittedly seldom the case in today’s low-rate environment.

The indexes that govern ARMs include but are not limited to Treasury bills, Treasury Constant Maturities (TCM), 11-th District Cost-of-Funds (COFI) and London Interbank Offer Rate (LIBOR). Some lenders use more complicated indexes, such as the Moving Treasury Average (MTA), or the Federal Cost of Funds (Fed COF) that averages all outstanding Treasury notes and bonds. The lender will then add a markup called a margin and set this level for the next fixed period of time.

In recent years so-called “hybrid” or “delayed-adjustment” ARMs have gained popularity. For example, a 7/1 hybrid ARM functions as a fixed-rate mortgage for 7 years and after that the rate begins to fluctuate. This is a great option for home owners who plan to move out after 7 years or earlier before adjustments begin. The shorter the fixed-rate period, the lower the rate is for a hybrid ARM. Hybrid ARMs typically carry an additional protective feature: “first adjustment cap” that applies only after the fixed-rate period of the hybrid comes to an end. For example, you may be offered a 2/2/5 cap structure where the first adjustment cap is 2%, the periodic cap is also 2%, and the lifetime cap is 5%.

If you opt for an ARM, you need to see how often adjustments are made. A monthly adjustment can be too much volatility. Most ARMs adjust every year with the lender setting the new rate about 45 days before the anniversary of the mortgage, based on the underlying rate. Other ARMs adjust every three months, every six months, every three years or even every five years. Longer fixed rate periods save you anxiety but are combined with higher interest rates.

Some borrowers manage to take advantage of the lower ARM rates by taking short-term ARMs of a year or less, and refinancing later if the first adjustment is upward. Thus, the first year they get a rate lower than the regular FRM rate, and then switch to a common fixed-rate loan.

FRMs, on the other hand, are more easily manageable, clear even to an inexperienced home-buyer, and most importantly, guarantee stable payments that help a family budget. This stability comes at a price in the form of higher rates. True, the homeowner can refinance if the rates post a significant drop, but refinancing comes with extra costs, while borrowers who chose ARM can take advantage of a rate drop without bothering about refinancing.

When making your choice between the two options, you can consider the following:

FRMs make more financial sense at the time of historically low rates as they allow borrowers to lock in low rates for the life of the loan.
The decision to choose an ARM or FRM also depends on the length of time the home owner plans to stay in the house. Families who plan to move in a short while can get an ARM since they will not be exposed to drastic rate changes for a long time stretch.
Borrowers also need to make provisions for a possible rate hike and see if they will still be able to afford monthly payments. You may want to protect your budget by choosing an ARM that is convertible to a fixed-rate mortgage.
If you plan to sell your house, choose an assumable ARM that may transfer your mortgage to the buyer – a desirable option if the rates are high.