[shareaholic app=”share_buttons” id=”24213484″]

Fixed rate loans versus ARMs is a hotly debated topic. Proponents of each product have strong arguments why their particular favorite is better than the other. I have seen numerous mathematical examples proving ARMs are better than fixed and vice versa. So what is the truth?

**Which is better the ARM or the fixed rate loan?**

**Which is better the ARM or the fixed rate loan?**

The answer to this questions lies in the particular financial situation of the borrower and their tolerance for risk. A properly selected mortgage is not a simple math exercise to determine which loan has the lowest interest rate. While an ARM has a lower introductory rate than a fixed, if the borrower is risk averse the ARM, is not the right loan. A mortgage is a personal product, it must fit the needs and risk tolerance of the borrower.

**ARMs – Some Basics**

**ARMs – Some Basics**

Now, lets take a minute to explore ARMs. An ARM is an Adjustable Rate Mortgage. At specific periods of time the rate may go up or it may go down. The most common ARMs in the mortgage world are 5/1 or 7/1. The first number is the number of years before the first adjustment. The second number is the number of years before each subsequent adjustment. So a 7/1 ARM is an ARM that remains fixed for the first 7 years and then it may adjust depending on market conditions each 1 year thereafter.

Let’s go a bit further with our understanding of an ARM. ARMS are tied to an index – such as LIBOR. The interest rate of the ARM will adjust according to its index. The margin is the interest percentage added to the index rate. Hence a fully indexed rate is the index plus the margin.

*CAPS – Know your CAPS & you will know your risk*

*CAPS – Know your CAPS & you will know your risk*

CAPS and margin are very important when analyzing the potential benefits and risks associated with an ARM. CAPS are quoted using three numbers such as 2/2/5. In this example the first “2” represents the CAP on the

*initial*adjustment after the fixed rate period. The second “2” represents the maximum adjustment that can be made in*subsequent*periods. The “5” represents the*maximum*adjustment from the original interest rate over the lifetime of the loan.So our previous example of a 7/1 loan with a 2/2/5 CAP – the loan will make its first adjustment in 7 years and the maximum amount the interest rate can rise is 2%. The loan will then adjust every 1 year thereafter and the maximum adjustment each period is 2%. The maximum amount the loan can adjust in its lifetime is 5% from the original rate.

*Which is best: The ARM or the fixed rate? *

*Which is best: The ARM or the fixed rate?*

Okay, now that we have a basic understanding of the ARM, how do we determine which is the best product for the buyer?

The first question we must ask is about risk tolerance. How much risk does the borrower comfortably want to take? This is a personal question that only the borrower can answer. An ARM that is comfortable for me might be too risky for another individual. Neither of us is wrong and neither of us is right – it is a question of how much financial risk we want in our lives. It is the responsibility of the loan officer to do the math and then let the customer decide which is the best option for their family.

**In the United States, the average 30 year fixed loan is refinanced every 7 years.**

One more piece of important information – In the current economic climate, the average 30 year fixed rate loan is refinanced every 7 years. At a minimum, the borrower must take this into consideration and understand the implications of refinancing a 30 year fixed loan in 7 years.

Remember, in a 5/1 or even a 7/1 ARM, the interest rate is significantly lower than a 30 year fixed. The borrower will pay less interest and earn more equity in the home in the initial periods for an ARM. The web is replete with examples that will prove this very point. If you can tolerate risk there is an opportunity to save interest expense in the first years of your loan.

**Remember two important features of most fixed rate loans.**

**Remember two important features of most fixed rate loans.**

If the risk of an ARM is burdensome, than remember two very important features of today’s fixed interests rate loans.

- No prepayment penalty
- Fixed interest rates are also at historic lows.

A conventional and/or government loan does not included pre-payment penalties. If a fixed loan gives you peace of mind – by all means get a fixed rate loan. However, remember this – there are significant savings in interest expense associated with paying extra principle each month on a fixed rate loan. This is especially true in the first half of its term. A fixed rate loan charges 60 to 75% of its interest expense in the first half of the loan. Thus, paying more principle in the fist 15 years of a 30 year loan doesn’t match the features of an ARM, but it certainly saves significant interest expense while providing the peace of mind of a fixed rate loan.

Which brings me to my final point. Do business with a lender that will do the math and help evaluate the costs and risk associated with different loan products. It is irresponsible to make a blanket statement that one loan is better than another without understanding the specific needs of each borrower.

As always – Happy House Hunting!

Mike

@michaelfnelson2

Skype: michael.nelson2014

Skype: michael.nelson2014

NMLS: 1314188

Licensed in:

Licensed in:

[shareaholic app=”follow_buttons” id=”24285563″]