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Tuesday, August 22, 2006

Basic Terminology: Fixed vs. ARM

There are two main types of mortgage products available: fixed rate and adjustable rate. Fixed rate products have the same interest rate for the entire life of the loan, while adjustable loans have a rate that varies over time.

Fixed products are usually identified by the loan term, such as 30 year fixed, 20 year fixed, 50 year fixed etc. The rate at the time the loan is closed is used to calculate the monthly payment, and both the rate and the payment are fixed from that point on.

Adjustable rate mortgages (ARMs) on the other hand behave like a fixed rate mortgage for some period of time, but after that the rate can change. These products are generally identified by names such as 7/1 ARM, 3/1 ARM, 1 year ARM etc. The first number specifies the the length of the fixed rate period and the second number indicates how often the rate can change after that. In the case of the 7/1 ARM the rate is fixed for the first 7 years, but will adjust once a year from then on. ARMs also have a total loan term, such as 20 or 30 years.

The rate adjustment for most ARMs is based on an index and a margin. The index is a published rate, such as the LIBOR (London Interbank Offered Rate) or the Prime Rate. The margin is the amount added to the index rate to determine the new interest rate for the period. For example, if your loan is tied to the LIBOR index with a margin of 4 you would expect to see your mortgage interest rate at 8% when the LIBOR rate is 4%.

In most cases a rate adjustment on an ARM also triggers a corresponding change in your monthly payment, but not always. Loans that do not include payment changes are referred to as Negative Amortization loans. These are usually a bad idea, since when rates go up your monthly payment is no longer covering the interest on the amount borrowed. Since all accumulated interest must be paid this can lead to a large balance due at the end of the loan term.

Fixed rates are almost always higher than an ARM with the same total term, at least for the introductory period. After that period the ARMs have the potential to adjust upwards, potentially leading to a rate greater than the fixed counterpart. Of course it could also go down, and may do both several times over the life of the loan. The shorter the fixed period the lower the introductory rate will be, with a 3/1 ARM being priced lower than a 7/1 ARM etc.

A good strategy when considering between a fixed rate or adjustable rate mortgage is to think about how long you intend to be in the house. For a starter house that you will only have for a few years until kids come along a 7/1 ARM might be the best option. You will get the benefit of the lower rate and then sell the house before the adjustments kick in. Just make sure you either sell or refinance before the end of the intro period, or you could be stuck with a higher payment.

ARMs are also widely used to help borrowers qualify for a little larger loan. Your debt ratios are calculated based on the first year's monthly payment, so borderline borrowers can choose an ARM with a lower rate that gives them a lower payment and qualify where they otherwise might not. This can be risky though since you may not be able to handle the increase in payments once the intro period is up.

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