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Understanding Your Loans: Fixed and Adjustable Rate Mortgages Explained

November 1st, 2008

fixed-adjustable-rate-mortgage.jpgThis article by Julianne Kelsch provides a brief explanation of fixed rate and adjustable rate mortgage loans. Overall, fixed rate mortgages are best when prevailing interest rates are low (like they are right now, for instance) because you can lock in these rates and do not need to worry about your payments suddenly increasing whenever the Fed decides to raise the rates in the future. Adjustable rate mortgages may be worth considering during periods when interest rates are higher and you are planning on selling or flipping the house within the next few years. Meanwhile, if you have already decided on the basic loan type and are simply wondering about how to deal with the paperwork, you can look at my previous article on What to Bring When Applying for a Mortgage.

You’ve finally done it — found the home you are going to buy. Now it’s time to procure financing. The loan institution is going to give you a few different loan/mortgage options. The two most popular are the fixed rate mortgage (FRM) and the adjustable rate mortgage (ARM). As a homeowner you will need to have at least a basic understanding of both loans to make an informed, educated decision.

The Fixed Rate Mortgage

The fixed rate mortgage is fairly simple and easy to understand. With this mortgage you will have an interest rate that never changes for the life of the loan. The interest rates in the economy are guaranteed to fluctuate, but your rate will not follow economical patterns. As a general rule, the interest rates for the FRM are higher than those for an adjustable rate loan, but the FRM is more stable. You will be able to budget your money more easily because the monthly payment for your house will not change, and you will not be hit with any adjustment on your payment.

The Adjustable Rate Mortgage

The adjustable rate mortgage is a bit more complex than the fixed rate mortgage. With the ARM you will be given a fixed interest rate for 3, 5, or 7 years. After that time the loan will be converted to an adjustable rate. An ARM is enticing because the initial interest rate is low, and it has low qualifying rates so you may be able to qualify for a bigger home. However, after the initial “fixed” period, your interest rate will jump to whatever the interest rates are at the time of the adjustment. At this point the loan becomes a gamble. If the interest rates are lower than your start-up rate, your payment will decrease, but if the rates are higher, your payment will increase. Once it becomes adjustable, the interest rate on your loan will be adjusted monthly. Your payment will be adjusted annually.

Each of these loans has its pros and cons. The FRM is ideal if you are planning on staying in your home for a good many years. You will never have to worry about the payment changing on your original loan. Your payment will be predictable and easy to budget around. The ARM loan is great if you know you will only be in the home for a few years. You will have a lower start-up interest rate, which equates to a lower monthly payment, and you may be able to sell your home before the interest rate adjusts. As always, do your research before making your final decision. An informed customer is the best customer.

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