Written by Jayant Row in Mortgages
Viewed by 57 readers since 04-14-2009
In a fixed rate mortgage or FRM the interest rate remains fixed throughout the period of the loan and the borrower knows that he has to make the same payments throughout the period of the loan. So, the payments will remain fixed and only variations may come in the property taxes and insurance where due. Short term FRMs will generally have a lower rate of interest than a long term one as the lender has to take the risk of the cost of the funds rising above the returns that he expects to make.
An adjustable rate mortgage or ARM is a loan given against property where the interest rate is periodically adjusted based on certain indices like COFI (Cost of Funds Index) or LIBOR (London Interbank Rate) Some institutions may not use these indices, but adjust the interest they charge on mortgages that will relate to their own cost of borrowing. In an ARM you are never sure of the interest payments that you make as these may be revised downwards or upwards. In an ARM the lender transfers the risk that he has taken while arranging funds to the person who has borrowed funds from him. Adjustment periods of these mortgages could be one year, three year or five year depending on the original agreement. There may be a cap on the increase or decrease. This is agreed to at the time of starting the ARM.
Lenders often offer discounts during the initial period of an ARM to attract borrowers to opt for this. In such cases the initial adjustment of rates may occur as soon as one year, and as this follows the market condition at that time can be quite steep and disconcerting to many a buyer. This can even because the borrower to default on payments as the sudden increase may be beyond his payment capacity.
In the case of FRMs, the borrower is always sure of the payments to be made, and may only feel that he is spending more money if interest rates go down. He is of course happy when interest rates go up and he remains unaffected. An FRM borrower is generally surer of his financial position as he has already factored in the interest payments into his financial planning and is not concerned with interest rate changes.
So how does one decide on the type of mortgage that is suitable? You need to make a very thorough assessment of your short term and long term goals for the property and your present and projected financial situation. Fixed rate mortgages over the long term are likely to have a higher interest rate. Adjustable rate mortgages on the other hand may have lower interest rates in the beginning, but could go up during the tenure of the loan. If you are lucky these rates could even reduce and thus bring you more saving in the cost of the final product.
Deciding on the type of mortgage that one takes is always a gamble and there is really no definite answer to which is the right one. After all the period of a mortgage is in years, generally over twenty, and it can only be a fool hardy person who can dare to predict where the markets and therefore the interest rates will be in the years to come. Whatever choice you make, the only thing to do is to learn to live with it and continue to make those payments so that your property is not at risk.