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Refinancing: Fixed Rate vs. ARM

Written By:
July 28, 2010 at 8:48 PM

The record lows that mortgage rates have hit this year have gotten a lot of people thinking about mortgage refinance. When these individuals start looking into refinancing they are faced by the old question: which is better a fixed rate mortgage or an adjustable rate mortgage (ARM)?

The best way to answer this question is to take a look at fixed rate mortgages and ARMS and see how they work. Once a person knows how fixed rate mortgages and ARMS actually work they will see that a fixed rate mortgage is the better choice right now.

Fixed Rate Mortgages

A fixed rate mortgage or FRM is the traditional mortgage that most people are familiar with. This financing instrument is called a fixed rate mortgage because it has the same interest rate throughout the life of the mortgage. The mortgage holder pays the same interest rate as long as they have the mortgage.

The rate on fixed rate mortgages is based on the mortgage interest rates at the time the mortgage is issued. Other factors such as the mortgage applicant’s credit score and the amount of the down payment may also affect the interest rate.

Generally fixed rate mortgages are better when the interest rate is low because they lock in the lower interest rate for the life of the mortgage. This means that a person who refinances to a 15 year mortgage with a fixed rate will pay 3.75% interest for the next 15 years regardless of the interest rate.

Those who refinance to fixed rate mortgages now will be able to enjoy the lower interest rates and lower payments that result from them for years to come. Interest rates are now at their lowest level since the 1950s so it is highly doubtful that we will see mortgage interest rates at these low levels again with our lifetimes. This means that a fixed rate mortgage has never been a better deal for the average person.

Why Adjustable Rate Mortgages Can Cost More

Many people will see adjustable rate mortgages advertised with lower interest rates than comparable fixed rate mortgages. That sounds like a good deal but it isn’t because the interest rate on most ARMS can start going up in two to four years.

The lower interest rate on the ARMS is only locked in for the first two to four years of the mortgage. This means that the interest rate can increase to almost 12% in the third or fourth year of the mortgage. This can occur because after the fixed rate period on an arm ends the interest rate can rise to the rate cap.

The average ARM today has an interest rate cap of 11.75% that’s almost 12% interest. This means that the interest rate on an ARM can go as high as 11.75% if the interest rate goes that high.

The interest rate on an ARM can affect the payment because the additional interest is added to the monthly payments on an ARM. In today’s market a person with an ARM on a $150,000 home could start out paying 5.75% interest which translates into a very affordable $878 monthly payment. This interest rate would be slightly higher because it would reflect the adjustments the mortgage company would make to the rate.

If the interest rate went up to just 7.75% the $878 monthly payment would jump to $1,075. That’s an increase of $197 a month or $2,364 a year on the mortgage payments.

If the mortgage rate increased to 9.75% the payment would be $1,289 a month or $15,468 a year. The highest possible interest rate on this mortgage would be 11.75% which would raise the monthly payment to $1,514 a month and increase the payments by $18,168 a year.

The mortgage interest rate is likely to stay at the present low level (under 4%) for the next year or so but it will go up at some point in the future. This could happen if the Federal Reserve raises rates or if inflation begins to affect the economy.

A sharp increase in the interest rate is most likely to occur three to four years from now. This would be about the time when the adjustable rate on most ARMS refinanced today would kick in.

Why Fixed Rate Mortgages are better than ARMS

This means that persons with fixed rate mortgages won’t have to worry about inflation or increased interest rates. They would be paying the same low interest rate as long as they held the mortgage.

Individuals who refinance to fixed rate mortgages will be able to avoid the effects of inflation and keep the record low interest rates for years to come. Naturally they will not have to worry about their mortgage payments suddenly increasing because of increased interest rates.

Obviously this is a very good time to refinance an ARM into a fixed rate mortgage. Persons who can refinance ARMS into fixed rate mortgages before the adjustable rate kicks in will be able to save money by keeping their mortgage rate low.

Adjustable rate mortgages are simply not a good deal with today’s interest rates. Anybody who has one should be able to save money in the future by refinancing it into a fixed rate mortgage.





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