Comparison Between A Fixed Rate and Adjustable Rate Mortgages

Most of the mortgages fall into two categories such as fixed rate mortgages and adjustable rate mortgages. These types of mortgages provide a number of options, which suit as per your need and requirement. It is always a difficult decision for borrowers to choose between fixed rate and adjustable rate mortgages. So, it’s important to understand and consider all the factors involved in such mortgages.

A Fixed Rate and Adjustable Rate Mortgages
A fixed rate mortgage (FRM) is a mortgage, where, monthly payment and interest rates remains constant throughout the mortgage term. A fixed rate mortgage is well known, because of the stability and a set of identical payments. During an initial interval of the term, interest payments are to be paid. After that, payment gets reduced based on the loan principal. Though payment is fixed, but, the principal amount varies depending on the interest rate. One of the major benefits of this mortgage is that, it protects a borrower from the economical crisis.

An Adjustable Rate Mortgage (ARM) is a mortgage, where, after initial interval, interest rate changes depending on the fluctuations in the financial market. Initial interest rates on an ARM are lower than offered by fixed rate mortgages. But, as the term goes on, the interest rate gradually increases and exceeds the rate of fixed rate mortgages. Interest rate on ARM depends upon the LIMOR rate or the treasury bills.

ARMs are more popular than FRMs due to lower initial payments and getting a high amount of loan. If the economy shows decrease in interest rates, payments get reduced. However, if a financial crisis comes, the payment amount may gradually increase.

Scenario Analysis
A scenario analysis is the best way to deal with the situation. If interest rate fluctuates in the market, scenario analysis gives an idea about monthly payment and interest rate value in ARM. It provides a way to reduce the risk of an ARM, by high payment, which you have been selected for FRM.

Scenario Analysis is made up of 3 cases: Best Case, Stable Case and Worst Case. Each case is showing interest rate and monthly payment. ARM scenario differs from the FRM scenario depending on monthly payment and interest rate.

The things which are required to make scenario analysis are as follows:

ARM Scenario Analysis
For ARM scenario analysis, you should have knowledge of all the features available in ARM.

This information is needed to calculate the interest rate and payment after 5 years. For this, we consider the current scenario of the 5/1 ARM with a 2.69 rate of interest. This rate is applicable for 5 years. Currently, an ARM rate is allowed with a one year Treasury index value of 0.29% with a margin of 2.75%. After 5 years, the interest rate will be adjusted every year. The ARM rate will be the index rate subject to an adjustment cap of 2% and a maximum rate of 8.69%.

Best Case:

A best case is an ideal ARM scenario. As per initial interest rate for first 60 months, the monthly payment is $405.08. With a lifetime cap of 6% , the next monthly payment after 5 years would be $407.78 with a margin of 2.75%.

Stable Case:

A stable rate scenario shows potential benefit of an ARM. If we consider 5/1 ARM with an interest rate of 2.69%, the payment would be $405.08. It is only for first 60 months.

After 60 months, the rate is adjusted. This adjusted rate can be calculated from the fully indexed rate (FIR).

The FIR is usually the best prediction of the rate on the first rate adjustment. It is the current value of the rate index used by the ARM, plus a margin which varies from one transaction to another, but stays the same through the life of any one ARM.

After 5 years,

Fully Index Rate= One Year Treasury Index + Margin
= 0.29% + 2.75%
= 3.04%

So, as per fully indexed rate, the monthly payment would be $421.03 thereafter, as compared to $464.82 on the FRM.

Worst Case:

A worst case scenario shows that the interest rate is increasing by 2% after first 60 months. As per current rate in the market, an interest rate is 2.69%, then, the payment would be $405.08 for first 60 months.

If we consider an increase of 2% in interest rate throughout the term, then, the payment will be $500.92 and $603.99 for respectively 4.69% and 6.69% rate of interest.

The maximum interest rate on the 30 year term would be the initial interest rate plus the lifetime cap. Thus, the maximum interest rate payable on a 5/1 ARM would be:

Maximum Interest Rate = Initial Rate + Lifetime Cap
= Initial Rate + 6.000%
= 2.69% + 6.000%
= 8.69%

Hence, the maximum monthly payment with the interest rate 8.69% would be $712.69, as compared to the $464.82 on the FRM.

FRM Scenario Analysis
It is quite often to have a verdict of FRM scenario analysis, due to fixed interest rate and monthly payment. As per current scenario, the interest rate for FRM is 3.78%. So, the payment for the 30 year term would be $464.82. Though economical market gets fluctuated and interest rates increases, this amount is constant throughout the term of the mortgage.

Comparison of FRM with Best Case ARM
When we compare FRM monthly payment with the best case ARM, it has been observed that, maximum monthly payment for FRM is $464.82 and maximum monthly payment for a best case ARM is $407.78.

In this case, we can save $1029.42 on ARM mortgage. Thus, Best Case ARM will be preferable.

Comparison of FRM with Stable Case ARM
When we compare FRM monthly payment with the stable case ARM, it has been observed that, maximum monthly payment for FRM is $464.82 and maximum monthly payment for a stable case ARM is $421.03.

Comparison of FRM with Worst Case ARM
When we compare FRM monthly payment with the worst case ARM, it has been observed that, maximum monthly payment for FRM is $464.82 and maximum monthly payment for a worst case ARM is $712.69.

In this case, we can save $3833.58 on FRM mortgage. Thus, FRM will be preferable.

Conclusion
Choosing the right mortgage for you is a decision that can be considered carefully, and discussed with your financial consultant and loan provider. As per cases mentioned above, though ARMs may be ideal, but, when interest rate increases due to economic crisis, you may find yourself paying a significantly higher monthly payment.