Fixed Rates vs. Adjustable Rate Mortgages (ARMs)
Conventional mortgages may be fixed-rate or adjustable-rate mortgages. A 30-year fixed rate mortgage means it has a fixed interest rate for the 30 year term of the loan. The most common fixed terms are for 30 years, 20 years and 15 years.
An ARM is a type of mortgage in which the interest rate paid on the outstanding balance varies according to a specific benchmark. The initial interest rate is normally fixed for a period of time after which it is reset periodically, often every month. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin. The most common ARMS are for 3, 5, 7, and 10 years. This is a great option for people that know they will not be in the house for a long period of time. The ARM follows a shorter mortgage backed security than the 30 year, so the difference between ARMs and fixed rates can vary on the markets. It is always a great idea to ask for both before making your decision.
Example of 7/1 ARM with 6/2/6 caps and 2.25 margin:
This will be a 7 year with 1 year adjustments. This means it has a fixed rate for 7 years and then will adjust 1 time a year (after the fixed period). After the 84th payment (7 years) the ARM will adjust with the "index" plus the ARM's "margin." This can be a financial index, such as the LIBOR which is published in the Wall Street Journal. The margin is added to the index (LIBOR) and typically rounded up to the closest 1/8th. For instance, in July of 2014, the LIBOR is only .56. You would add .56+2.25=2.81 and then round up to the nearest 1/8th. This would put the rate at 2.875. Since the loan only adjusts 1 time a year, this would be the rate for 12 payments until the next adjustment. The 6/2/6 caps mean that the 1st adjustment could not ever go over 6% higher than the current rate. The 2 means that every adjustment after could only go up or down a maximum of 2%. The last 6 means that over the life of the adjustments the rate could never be 6% higher than the initial rate. So, if the rate started at 3% the maximum rate would never be over 9%.