Frequently Asked Questions / ARM vs. FRM
 

The question: "Should I get a fixed rate mortgage (FRM) or an ARM?"

An ARM, of course, is an adjustable rate mortgage whose interest rate can go up or down. By contrast, a fixed-rate loan locks in your rate for the life of your loan -- there's no need to guess as to where the rate will be next year or in 15 or 30 years.

At first glance, an ARM looks like a very good deal when compared to a fixed rate.  The 3/1 ARM rate is always less than the average fixed-rate.

The Gamble
However, there is a slight gamble involved and homebuyers who take out ARM loans should be well informed. (Try reading our ARM news section.)  With an ARM, your payments are lower for the first three or four years, and will stay low -- provided interest rates in general don't skyrocket.  If they do, the lender typically will adjust your ARM rate upward by a maximum of 2 percentage points per year, and a maximum of 5 percent over the entire loan period.

For example, an 3-year Adjustable Rate Mortgage (ARM) that starts out at 5.00% can increase to 7.00% in the fourth year, to 9.00% in the fifth year, and to 10.00%  in the sixth year.  Important:  This would only happen if normal mortgage interest rates were at 10.00% anyway.  In other words, a lender won't increase the interest rate on your ARM, just because they can!  Your ARM rate should always be "at market" or below market, when compared to a 30-year fixed rate mortgage.

On the other hand, when most interest rates are in a decline, such as they are right now, that tends to keep ARM rates low.

How ARM Rates are Computed
Few homebuyers understand how 3-year ARM rates are computed:  For the first 3 years, the lender uses a "teaser rate."  In the second year, they start tying the rate to a publicly known index such as the LIBOR or the Treasury Bill (T-Bill). The lender adds a "margin," usually 2.75 percent, to arrive at your new ARM rate.  This usually happens once per year, but some ARM loans adjust ever six months.

Very Important: However, pretend you are at 5% for the first 3 years of your ARM.  Then, in year four, the LIBOR index is at 4.50%.  The lender wants to add the margin of 2.75%, giving you a new rate of 7.25%, but they cannot!  Remember, there is a 2% yearly cap.  This means that the lender wants to give you 7.25% (the 4.50% index plus the 2.75% margin), but they have to settle for 7.00%.

Who should get an ARM?
When should you get an ARM -- or not get one? It depends on two things:

  1. How long you plan to remain in your home
  2. The unpredictable direction of interest rates.

A family that probably won't move again for five or more years should not consider an ARM at this point because fixed rates are relatively low.  It is far better to lock a fixed rate if you intend on staying in your home for a very long time.  To compare 30-year fixed rate mortgages from about a dozen major lenders, visit RateLab.com

By contrast, homebuyers who believe they'll be in their house for only four years or less will save a great deal of money by opting for a 3/1 ARM. Though their ARM rate may rise in year four, the bottom line, in dollars and cents, is that the buyer's total cost will be less than that with a fixed rate over the same time period.