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Adjustable Rate Mortgage vs Fixed Rate Mortgage - Should You Make The Switch?

The short answer to the title question is neither no nor yes. It is the ever uncomfortable, it depends. That big “maybe” won’t even provide a universal response to all adjustable rate mortgages (ARM’s) at any given time. Because not all ARM’s are the same, what may be true of mine today may not be true for yours. I trust that you are sensing that I am hedging my advice at every opportunity and am being decidedly non-committal. There is a very good reason for it and it’s not that I am wishy washy by nature, I’m not. It’s just that the underlying structure of adjustable rate mortgages is not same for all.

Find the right mortgage rate for you.

What’s the Difference

An adjustable rate mortgage is different than a conventional fixed rate mortgage in several ways. First, the interest rate of an ARM will fluctuate over the life of the loan while a fixed rate mortgage’s rate remains the same. Initial interest rates for ARM’s are generally lower than conventional mortgage rates. However, ARM’s carry the risk of having a higher rate at some point down the road.

How Do Adjustable Rate Mortgages Work

Adjustable rate mortgages rates have two kinds of interest rates. The initial rate is the starting rate of the mortgage and determines the initial payment amount. Then there is the variable rate. The initial rate remains in effect from anywhere between 1 month to 5 years or more. The interest rate and payment can vary between ARM’s depending on the adjustment period of a given loan (from months to years). That’s one of the “depends” I mentioned at the start.

Index and Margin

Adjustable Rate Mortgage vs Fixed Rate Mortgage - Should You Make The Switch?

Another and very significant variable is how the interest rate on your ARM is determined. Most ARM’s function the same underlying way where index + margin = rate. However, each of these may be different depending on the lender. The numbers can even vary between multiple loans from the same lender.

What is the index and margin? Index is the base against which your interest rate is determined. Margin is the percentage amount that lenders add to the index to determine your interest rate. While the index rate measures interest rates in general, that pesky “depends” comes very much into play here. This is because different lenders will base their index rate on different indices.

CMT – COFI – LIBOR?

Most people outside of Wall Street and banking are unfamiliar with these acronyms. This includes people who carry mortgages based on these acronyms. CMT is the 1-year constant-maturity treasury rate, or the average yield on United States Treasury securities adjusted to a constant maturity of 1 year. COFI stands for the cost of funds index. COFI is computed from the actual interest expenses reported for a given month by savings institutions. The London Interbank Offer Rate, or LIBOR, states the rate at which 18 large banks (under the British Bankers’ Association) can reasonably borrow from each other.

These are only some the indices that banks use to determine ARM rates. Some banks create their own index and others use different ones altogether. The rates these indices reflect at any given time can differ substantially. The amount and frequency that they fluctuate can also be dramatic. This explains why you and I could have taken out ARM’s on the same day with the same starting interest rate, but 5 years laterm your interest rate can be 2% lower than mine.

Interest Rate Caps

Yet another variable called the interest rate cap comes into play when discussing ARM’s. The interest rate cap comes in three flavors: initial, periodic and lifetime. These will vary from lender to lender and loan to loan. The initial cap indicates how much the interest rate can increase in its first go around. The periodic cap refers to the maximum amount the ARM’s rate can increase with each subsequent pass. Finally, the lifetime cap gives the maximum amount an ARM’s rate can reach over the lifetime of the loan.

There’s a Flag on the Play

Adjustable Rate Mortgage vs Fixed Rate Mortgage - Should You Make The Switch?

You guessed it! I’m talking about penalties such as pre-payment, partial pre-payment and conversion penalties. Spending money to save money (paying the penalty) really depends on the long term outlook for your particular mortgage. Many ARM’s include penalties for full or partial pre-payment. But sometimes pre-payment could be your only option if your loan does not allow conversion. If you see this problem as a possibility in your future, then an ARM may not make sense for you in terms of long-term cost.

Pre-payment penalties come in a wide range of forms and amounts. Some run on a sliding scale that decreases as the loan matures. Others restrict when they can be exercised, such as only on the loan anniversary. Some may be limited to the first 5 years or prohibit pre-payment before 5 years. The wisdom of absorbing possible penalties really truly depends on the terms of your loan.

Look Before You Leap

If you do not yet have a ARM, don’t let me dissuade you from acquiring one. They can save you substantial amounts of money over the life of your mortgage. However, I do strongly suggest that you go beyond the information in this article. Try reading the Federal Reserve’s Consumer Handbook on Adjustable Rate Mortgages. Also be sure to do your homework and read disclosures from multiple lenders before signing on the dotted line.

Maybe you already have taken the leap and have an adjustable rate mortgage, but are considering conversion or refinancing. In that case, don’t be in too much of a rush to jump off the cliff and get out. Research the index tied to your loan and compare its historical performance to current trends. Then you can make a reasonable assessment about what the future holds for your interest rate.

Final Word

All of the factors described above will help you determine whether an ARM works for your situation. It is not a decision that could or should be based on what others are doing or suggesting, unless they are intimately familiar with the terms of your loan and your personal circumstances. The best advice I can offer as to whether or not it’s better to switch to a fixed rate mortgage is that it “depends” on you.

Photo credit: ©iStock.com/Gajus, ©iStock.com/Weekend Images Inc., ©iStock.com/Chimperil59

Frank Addessi Born and raised in the center of the known universe, Brooklyn NY, and currently hiding out in the bucolic hills of northeast Pennsylvania writing about personal finance. His expertise includes personal loans, credit cards and retirement. It's not easy living the American Dream but someone has to do it!
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