Generally we can categorize the mortgages into Fixed Rate Mortgage (FRM) and Adjustable Rate Mortgage (ARM). With Fixed RateMortgage, the interest rate is locked in for the life of the loan and monthly payment remains the same throughout the duration of the term. With Adjustable Rate Mortgage, the interest rate is not locked in for entire loan term, at certain point of time, rate will fluctuate based on market interest rate environment.
Even though you have a fixed rate mortgage, your monthly payment may vary if you have an “impound account”. In addition to the monthly principal and interest payment, lender may collect additional money each month (for example from homeowners who put less than 20% cash down when purchasing their home or had less than 20% equity when refinancing their home) for the prorated monthly cost of property taxes and homeowners insurance. The extra money is put in an impound account by the lender who uses it to pay your property taxes and homeowners insurance premium when they are due. If either the property tax or the insurance happens to change, your monthly payment will be adjusted accordingly. However, the overall payments in a fixed rate mortgage are very stable and predictable.
- Rates and payments remain constant, despite what happens in the broader economy
- Easy to manage your finance and budget
- Simple to understand
- Best for homeowners who will stay in a house for many years
- You may be locked in a relatively higher rate. To take advantage of future lower rate environment, you need to go through refinance process
- you are also locked in the amount of minimum monthly payment. If you paid down a big amount of principal, normally you will not be able to adjust your minimum monthly payment unless lender grants exception or you go through refinance procedure.
The most popular type of adjustable-rate mortgage today is Hybrid ARM, which is the mix of fixed rate and adjustable rate. Typical Hybrid ARMs are 3/1, 5/1, 7/1 and 10/1 ARM. The rates for these hybrid ARMs are fixed for initial 3, 5, 7 or 10 years and monthly payments are amortized over 30 years. After initial 3, 5, 7 or 10 years fixed rate period, your rate will be reset once a year and your minimum monthly payment will be adjusted every 12 months as well according to the loan balance, remaining term and interest rate at that time.
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year, but there are factors limiting how much the rates can adjust. These factors are called “caps”. Suppose you had a “3/1 ARM” with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 4.25%. The highest rate you could have in the fourth year would be 6.25%, and the highest rate you could have during the life of the loan would be 10.25%. Most of ARMs also have a 2% periodic cap which means maximum rate adjustment every year after initial fixed rate period is 2%. For example 3/1 ARM, if fourth year rate is 6.25%, fifth year rate can not be more than 8.25% or lower than 4.25% due to 2% periodic cap. An ARM loan also has an interest rate floor meaning the lowest rate you may pay during the life of the loan. The floor can be the margin or initial note rate. In case of negative interest rate environment, your lowest rate could equal to margin or your initial note rate.
The beauty of a Hybrid ARM is that the initial interest rate for the fixed period of the loan is lower than the rate would be on a mortgage that’s fixed for 30 years. Hence you can enjoy a lower rate while having period of stability for your payments. You can also refinance as the initial fixed rate period expires. By getting a lower rate and lower monthly payments than with a 30 year fixed rate loan, you can break even more quickly on refinancing costs, such as title insurance and the appraisal fee.
- Feature lower rates and lower monthly payments during initial period of the loan term.
- Allow borrowers to take advantage of falling rates without refinancing.
- Best for homeowners who will not stay in the house or hold the mortgage for long run
- Build equity faster due to lower rate during early stage of the loan
- Rates and payments might rise significantly over the life of the loan.
- Interest rate structures are more complicated
- More difficult to budget accurately