LESSON 5: ARM vs. FRM
ARM benefits and drawbacks:
Which is the better mortgage option for you:
adjustable or fixed?
Adjustable-rate mortgages can be very tempting to home buyers,
yet they carry a great deal of uncertainty. Fixed-rate mortgages
offer rate and payment security, but they can be more expensive.
Here are some pros and cons of ARMs and FRMs:
Feature lower rates and payments early on in the loan term.
Because lenders can use the lower payment when qualifying borrowers,
borrowers can purchase larger homes than they otherwise could
2) Allow borrowers to take
advantage of falling rates without refinancing. Instead of having
to pay a whole new set of closing costs and fees, ARM borrowers
just sit back and watch their rates fall.
3) Help borrowers save and
invest more money. Someone who has a payment that's $100 less
with an ARM than with a FRM for a couple of years can save that
money and earn more off it in a higher-yielding investment.
4) Offer a cheap way for
borrowers who don't plan on living in one place for very long
to buy a house.
Rates and payments can rise significantly over the life of
the loan. A 6 percent ARM can end up at 11 percent in just
three years if rates rise in the overall economy.
2) A borrower's initial
low rate will adjust to a level higher than the going fixed
rate level in almost every case even if rates in the economy
as a whole don't change. That's because ARMs have initial
fixed rates that are set artificially low.
3) The first adjustment
can be a doozy because some annual caps don't apply to the
initial change. Someone with an annual cap of 2 percent and
a lifetime cap of 6 percent could theoretically see the rate
shoot from 6 percent to 12 percent 12 months after closing
if rates in the overall economy skyrocket.
ARMs are difficult to understand. Lenders have much more flexibility
when determining margins, caps, adjustment indices and other
things, so unsophisticated borrowers can easily get confused
or trapped by shady mortgage companies.
5) On certain ARMs, called
amortization loans, borrowers can end up owing
more money than they did at closing. That's because the payments
on these loans are set so low (to make the loans even more
affordable) they only cover part of the interest due. Any
additional amount due gets rolled into the principal balance.
FRM benefits and drawbacks:
Rates and payments remain constant. There won't be any surprises
even if inflation surges out of control and mortgage rates head
to 20 percent.
2) Stability makes budgeting
easier. People can manage their money with more certainty because
their housing outlays don't change.
3) Simple to understand,
so they're good for first-time buyers who wouldn't know a 7/1
ARM with 2/6 caps if it hit them over the head. Plus, longer-term
FRMs are very affordable.
To take advantage of falling rates, FRM holders have to refinance.
That means a few thousand dollars in closing costs, another
trip to the title company's office and several hours spent digging
up tax forms, bank statements, etc.
2) Can be too expensive for
some borrowers, especially in high-rate environments, because
there is no early-on payment and rate break
3) Are virtually identical from
lender to lender. While lenders keep many ARMs on their books,
most financial institutions sell their FRMs into the secondary
market (more about that in Lesson
10). As a result, ARMs can be
customized for individual borrowers, while most FRMs can't.
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