Understanding Adjustable Rate Mortgages / ARM
Fixed rate mortgages
Fixed rate mortgages are easy to understand; the mortgagor (borrower) agrees to pay back a loan to the mortgagee (lender) at an interest rate that never changes. For example, a “30-year fixed” mortgage is the most common mortgage. The borrower agrees to pay back the loan over 30 years at a rate that is “fixed” and never changes. There are also 10, 15, 20, and 25 year fixed options.
Adjustable rate mortgages (ARM)
Also called a variable-rate mortgage or tracker mortgage, these mortgages have interest rates that may fluctuate periodically. The most common types of ARMs have interest rates which are fixed for a period of time (the “initial interest rate”) and adjust after that time passes (the “adjustment period”). There is usually a limit on how much the interest may adjust (the “interest rate cap”).
Tip for those moving to or from the United States to another country: Fixed rate mortgages are most common in the United States. In other countries, ARMs are the most common. Fixed rate mortgages may not even be available in some countries!
ARMs are usually described as two numbers separated by a slash. The most commonly seen ARM is the 5/1. The 3/1, 7/1, and 10/1 are also very common. The first number is the adjustment period. The second number is the number of times the rate will adjust after the adjustment period. This means that a 5/1 keeps the initial interest rate for five years and the interest rate will adjust annually every year thereafter. The 3/1 is keeps the rate for three years, 7/1 for seven years, and 10/1 for ten years.
So which is better?
While an ARM’s initial interest rate is lower than a fixed rate mortgage, most borrowers today seek fixed rate mortgages. This is because interest rates are (as of July 2017) still near historic lows. Interest rates will only rise as time passes. Therefore, it makes sense for most buyers to lock into an already low interest rate with a fixed rate mortgage. However, if a buyer knows they will move in a number of years (for example, a temporary work assignment of 5-7 years), it may make sense to use an ARM.
Mike Kwiatkowski is a Broker Associate with Coldwell Banker Residential Brokerage of Brookfield, WI. He welcomes your questions about mortgages, the real estate market, and the housing industry! Please don’t hesitate to email or call 414-207-2938.