My Real Estate Blog

Fixed Rate Mortgages (FRMs) come with an interest rate that is fixed for the life of the loan. For the borrower, that builds in budgeting security -- the mortgage payment remains the same each month.

Not so with Adjustable Rate Mortgage (ARMs). They come with an interest rate that changes throughout the life of the loan. How often and by how much the rate changes, depends on the terms of the ARM, but their appeal is an initial rate that is lower than FRMs that gives the borrower the power of financial leverage to initially pay less a month for the same mortgage than they would pay for a FRM. ARMs can also help a buyer buy a larger home or more expensive home.

In recent weeks, for conforming, 30-year mortgages, the interest rate on FRMs have averaged about one percentage point higher than the 5-year Treasury indexed ARM.  That's about $2,000 a month on a $400,000 mortgage for the FRM and $1,785 for the ARM -- a savings of $215 a month for the 5-year ARM's first five years.

But here's the rub.

ARMs come with a starting rate for a given period. The rate remains the same, typically, from one year to 10. After the initial period, the rate changes, typically each year. A "5/1" ARM, for example, is fixed for five years and then resets each year thereafter.

How much the rate changes depends upon the "index," which can rise and fall; "margins," which, when attached to the index, add up to your current interest rate; and maximums or "caps" that limit the size of the rate increase during each period and how high the rate can go during the life of the loan. "Floors" also limit how low a rate can go.

Because the margin is set with the terms of the loan, the interest rate is at the mercy of the index.  Common indexes are the 12-month Libor (for London Interbank Offered Rate) and the 1-Year Treasury.

The week of Nov. 30, 2010, put the 12-month Libor at 0.785 percent and the 1-Year Treasury at 0.26 percent.

Average margins run about 2.25% to 3%, hence the recent average 3.45 percent rate on the 5/1.

The risk, however, remains.

FRMs remain today's most popular type of loan because there's a demand to lock in and avoid the potential pain of rising rates that could come with the housing markets projected recovery in late 2010.