Fixed vs Adjustable Rate Mortgage

What is the difference between a fixed rate and an adjustable rate mortgage?

1 Answer

This distinction between a fixed rate mortgage and an adjustable rate mortgage is important to understand. A fixed rate mortgageis simply a mortgage where the note rate is fixed for the entire life of the loan until the loan is paid off. The reason I did not say the payment was fixed because certain lenders will allow a loan to be re amortized (recalculated) after a certain amount of time or if a large lump sum payment is made towards the principal. The only way the rate on a fixed rate mortgage can be changed is thru a refinance of the original loan or thru a loan modification.

An adjustable rate mortgage is a mortgage that has a fixed interest rate set by the lender for a certain time frame and can adjust up or down after the initial time frame expires. There are two components to an adjustable rate mortgage that determine its rate after the initial fixed period. These two components are the index and the margin. When figuring your interest rate on an adjustable rate mortgage always take the (current index value + the margin) to figure your true interest rate more commonly referred to as your fully indexed rate. The acronym I use is I+M= Rate.

The index is an indices tied to certain financial measurements. The most common index’sassociated with adjustable rate mortgages are the LIBOR and COFI. The LIBOR is the London Inter Bank Offered Rate. Simply this is the rate at banks loan and borrow money from each other in the London wholesale money market. The COFI is the Cost of Funds Index. Investopedia defines this as “A monthly weighted average of the interest rates paid on checking and savings accounts offered by financial institutions operating in the states of Arizona, California and Nevada.  Published on the last day of each month, the COFI represents the cost of funds for western American financial institutions.”

The index portion is the adjustable piece in the adjustable rate mortgage formula.

The second part of an adjustable rate mortgage is a margin. The margin is the constant or fixed portion in the adjustable rate mortgage formula. This is the portion set by the lender. Thru ought my years I have seen the margin be set as low as .75 and as high as 4.25%. However, most margins are set at 2.5%.

All adjustable rate mortgages have adjustment caps as well. The two most typical caps are 2/2/6 and 5/2/5. These caps set the rules for adjustments after the initial fixed interest rate period. The first number in each set represents the maximum the interest rate could rise or the minimum it could fall on its first adjustment after the fixed term. The second number represents the number of times the rate can adjust each year. The final number represents the maximum and minimum the interest rate could adjust over its initial fixed rate. So with the 2/2/6 caps, the first 2 means the rate could adjust 2% up or down from the initial fixed rate on its first adjustment. The second 2 means that it will adjust 2 times a year (every six months). Then the 6 means that the interest rate can never be higher than 6% over the initial fixed rate and lower by no more than 6% from the initial start rate.

I know this is a lot to swallow but stay with me. I’ll bring it all together in the next paragraph.

For example, I have a client who got into a 3/1 LIBOR ARM at 5.875% with a .75% margin and 5/2/5 adjustment caps four years ago. This means his rate was fixed at 5.875% for the first 3 years. Because of the caps, his rate could never go higher than 10.875 (5.875 +5) or lower than .875% (5.875 – 5). It also meant he was going to have two changes per year to his interest rate every six months after his initial three years was up. Currently the 1 year Libor Index is at 3.17%. When you add this clients margin of .75% you get his full interest rate of 3.92.

While this client has been very happy with this loan product, it is important to work with a mortgage professional to determine if an adjustable rate mortgage or a fixed rate mortgage would be the best option for your current and long term needs. In my opinion, with the proper management and exit strategy along with an environment of Fed Rate cuts, an adjustable rate mortgage can be a beneficial loan program.