Many people have heard of fixed mortgage and adjustable rate mortgage (ARM).  What exactly are the differences?  Which is a better choice?  Truth is no clear right or wrong answers.

The differences

1.  Fixed Mortgage carries a fixed interest rate from day one to end of the term.  15 or 30 yrs are the most common ones;
2.  ARM comes with 2 components – adjustable portion called “Index”, usually LIBOR or US T-Bond.  Fixed portion called “Margin”, the fixed portion of the interest rate.  The Index, a short term interest rate, changes over time while the Margin is set at the beginning;
3.  5 or 7-yr ARM are popular.  Rates are fixed for the initial 5 or 7 yrs and become adjustable for the remaining 25 or 23 yrs.  Rates may be adjusted once a year, up or down.  Such rates have ceilings or caps on how much they can go in either direction per adjustment and throughout the term of the loan.

Pros and Cons

Fixed mortgage offers a peace of mind.  You know how much you need to pay each month, year in year out.  Easier for budgeting purpose.  However this comes at a cost – fixed mortgage carries a higher interest rate than ARM and the difference could be as wide as 0.75-1.00%.

Because of the lower initial rate on ARM, the savings could be significant.  Many people move, sell, refinance, or cash out on their mortgages over time.  Is it worth or necessary to pay premium for a fixed rate over 30 yrs really depends on the individual’s situation.  The best scenario for ARM is when rates stay around the same level or move lower.  The worst is when rates go up rapidly though ARM comes with different caps or ceilings limiting how high the rate could go.  The most an ARM could go up is usually 5% higher than the initial rate.