Fixed Rate Mortgage (FRM)

The traditional fixed rate mortgage is the most common type of loan program. Fixed rate mortgages charge a set interest rate that lasts the life of the loan, resulting in reliable monthly payments. A fixed interest rate, regardless of loan program, guarantees a consistent principal and interest payment throughout the life of the loan, which allows for a reliable and gradual amortization. Fixed rate mortgages are available in terms ranging from 10 to 30 years and can be paid off at any time without penalty. This type of mortgage is structured, or “amortized” so that it will be completely paid off by the end of the loan term. A fixed rate mortgage benefits the homeowner who doesn’t want to contend with loan repayment amounts that fluctuate with interest rate movements.

 

The only time the monthly payment on your fixed-rate mortgage may change is for escrow. In addition to the monthly loan payment, some lenders collect additional money each month for property taxes and home owners insurance payments.  The extra money is put in an escrow account, also referred to as an impound account, by the lender who uses it to pay the borrowers’ property taxes and insurance premiums when they are due. Property tax rates and insurance premiums adjust regularly (typically every 12 months) and your escrow will adjust in accordance.

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Adjustable-Rate Mortgage (ARM)

Adjustable-rate mortgages (ARMs) begin with a set interest rate, usually below the market rate on a comparable fixed-rate mortgage. ARMs are loans in which the interest rate can vary during the loan’s term. An ARM is a good choice if you expect your income to increase over time or if rates are expected to drop. It is also a good choice if you know that you will be selling your home in a relatively short time period.

 

When shopping ARMs, it’s common to see the initial rate and adjustment period represented in a short-hand fraction. For example, a 7/6 ARM will carry a fixed rate the first 7 years of the loan and then adjust every 6 months after.

The amount any rate adjusts will depend on the fully-indexed rate at the time of adjustment, as well as any adjustment caps in place to limit the amount the rate can go up or down. A fully indexed rate is the combination of the index and the fixed margin on the mortgage, both chosen by the lender.

The cap is also set by the lender. You will go over the specific terms of your ARM in detail with your loan officer. Some ARM loans have a conversion feature that would allow you to convert the loan from an adjustable rate to a fixed rate. There is a minimal charge to convert; however, the conversion rate is usually slightly higher than the market rate that the lender could provide you at that time by refinancing. It is important to understand the terms in full before accepting the loan. You should not just assume you can refinance later.