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Fixed Rate Mortgage Vs. Adjustable Rate Mortgage

Fixed Rate Mortgage Vs. Adjustable Rate Mortgage

The following article will help you in determining which mortgage out of the fixed and adjustable mortgage rate, you should choose - as per your needs.
WealthHow Staff
Mortgages are loans given by financial institutions or banking firms, after retaining some private property of an individual as a collateral with them. Fixed rate mortgage and Adjustable rate mortgage are the two most prominent types of mortgages. The mortgages offered in the market are varieties within these two types.

The major difference between a Fixed Rate Mortgage and an Adjustable Rate Mortgage is its interest rate. The rate of interest in a Fixed Rate Mortgage is fixed for the entire repayment term and the rate of interest on an Adjustable Rate Mortgage is fixed for a small period and is then fluctuating depending on the current credit rates in the market.

Fixed Rate Mortgage

The rate of interest charged in Fixed-Rate mortgage is constant throughout the loan period and also the amount you pay every month is fixed. This amount consists of the rate of interest and the principal amount. The amount you contribute for the rate of interest payment changes every month and so does the principal amount. These loans are normally allocated for 30, 20, 15 years.

Advantages
1. The amount to be paid every month is fixed. This helps the debtor to plan his expenses and budgeting.
2. Fixed rate mortgages also protects the debtor against the fluctuation in the interest rates as the rate of interest is constant throughout the repayment period.

Disadvantages
1. If the rate of interest goes down in the future; you still end up paying a higher rate of interest.
2. The monthly paid amounts are usually high.
3. The rate of interest charged are usually high as, you are paying a price to protect yourself against the future hike in the rate of interest for over a period of 15-30 years.

Adjustable Rate Mortgage

In case of adjustable-rate mortgages, the rate of interest on the loan changes over a period of time. The rate of interest charged in the initial period is fixed and then the rate increases with time. The period in which the rate of interest remains constant is fixed; but the period in which one can pay a fixed rate of interest varies from institutions to institution. The repayment amounts you'd pay every month would be different. The rate of interest on adjustable rate mortgage is based on the index rate or the prime lending rate. The fixed rate mortgage period lies between 10 months to 10 years and the loan period can go up to 30 years.

The most commonly used indexes in the US are:

1. Cost of Funds Index
2. London Interbank Offered Rate
3. 12 Month Treasury Index
4. Bank Bill Swap Rate
5. National Average Contract Mortgage Rate
6. Constant Maturity Treasury

There are three ways of applying the index to the rate of interest.

1. Directly
Under this way of determining the rate of interest, the interest rate changes as per the changes in the index. Normally, the contract rate index is applied directly.

2. On a Rate + Margin
In this case, the rate of interest will be specified as index plus a margin.

For example: The rate of interest would be specified as MTA (Month Treasury Average Index) + 1%. This 1% is the margin.

3. Indexed Movement
In this way of applying index rate, a rate on the mortgage is fixed and is then adjustable depending on the movement of the index. Here the rate of interest is not tied to the index but the adjustments in the index are.

Advantages
1. One main advantage in considering the Adjustable Rate mortgage would be benefiting from the lowering rate of interest.
2. Another advantage is that, the initial rate of interest is usually lowered by the bank; considering the risk you are taking, if the rate of interest increases in the future.

Disadvantages
1. A major disadvantage is that, if the rate of interest increases in the future, you end up paying a higher rate of interest.
2. You are not protected from the fluctuations in the credit market as your rate of interest change accordingly.

Which Loan Should You Opt For?

You can Opt for an Adjustable Rate Mortgage if...
1. You are willing to take the risk of increase in the rate of interest.
2. You are looking at the lower rate of interest charged in the initial period of the loan.
3. If you are okay with the changing annual payments.
4. If you do not qualify for higher rate loan programs, then this could be a good option.

You can Opt for a Fixed Rate Mortgage if...
1. You are willing to protect yourself against the increase in the rate of interest in future.
2. If you are looking at a fixed repayment amount and period.

Before opting for an Adjustable rate mortgage or a fixed rate mortgage you will need to thoroughly asses the following factors.
1. Amount and period of the loan
2. Current economic conditions
3. Future economic changes
4. How much are you willing to pay each month?
5. Are you looking at stability in terms of payments or are you looking at benefiting from the changes in the market conditions?

Ask your self the above mentioned points and calculate the opportunity cost of buying a Fixed Rate Mortgage or Adjustable Rate Mortgage and also compare the mortgage companies you are planning to buy your mortgage from. All this would help you in making the correct choice.