Fixed or Adjustable Rate Mortgage: Which One is Right for You?

Become knowledgeable about the 2 basic types of mortgages before you apply:
1. Fixed Rate Mortgage (FRM)
2. Adjustable Rate Mortgage (ARM)

As you can probably tell from the name, a fixed rate mortgage is one in which both the length of the loan the interest rate is set in stone. When you sign for the mortgage, the interest rate is a given percentage of the original value of the house and never deviates from that amount. A term of life for a fixed rate mortgage is 15 or 30 years.

Adjustable rate mortgages (ARMs) do, however, have payments – the principal plus the interest – that adjust or change with direct relation to the existing prime rate, Treasury bills, CDs, and the Cost of Funds Index (COFI) during the life of the loan. There are limits specified in the terms of the loan, however, for how much the payment can change throughout the loan. A cap of 2-3 percentage points over the course of a year, with a lifetime cap of 6 to 8 percent, is common.

Conditions in the lending industry change as the prime rates and financial markets that they rely on change. Thus, it is vital to consider aforementioned changes and how they would change your ability to repay the loan over its lifetime. You can do this by devising three financial scenarios and how they would affect you during the life of the loan before visiting a mortgage company to actually apply for the loan. By doing this, you will be able to gage if you should really apply for a particular loan amount. This is a very important step to take when considering a loan. For the following examples, we will not consider winning the lottery as a viable financial scenario.

1. Usual Scenario:
Projected monthly income and average projected monthly expenses

2. Worse than Usual Scenario:
20% less than projected average income and 10% above projected expenses (with cost of living increase a 4% added to yearly expense estimate).

3. Worst Possible Scenario:
No earnings, 6 Months of unemployment, add 5% cost of living increase to projected yearly expenses.

The scenarios that you have researched will allow you to choose a home that you really can afford. When going to a lender to actually apply, you can show an understanding of the various risks of an ARM as well as how much of an increase in a monthly mortgage payment you can withstand. By paying your bills in a timely manner and establishing great credit, you can show a lender that you are not a risk, but a good customer.