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ARM vs. FRM

The first step in selecting from a range of mortgage offers should be a choice between an FRM (fixed rate mortgage) and an ARM (adjustable rate mortgage).

With an FRM, the interest rate remains fixed throughout the mortgage term. With an ARM, the interest rate may change during the term, after an agreed fixed-rate period ends.

The rate changes in ARM-type mortgages are based on an index agreed upon with the lender. The index reflects the situation on the real estate market – for example, it can cause the interest rate to increase during periods of market growth. The initial fixed-rate period can be as short as a month or as long as 10 years, after which the lender will start to adjust the interest rate.

The low initial interest rate resulting in low monthly payments of ARMs can be very attractive to homebuyers. However, adjustable-rate mortgages involve considerable uncertainty since the monthly payment may rise unexpectedly.

One-year ARMs are the most common. Recently so-called hybrid ARMs have gained popularity. Hybrid ARMs – often referred to as 3/1, 5/1, 7/1 or 10/1 loans – have fixed rates for the first three, five, seven or ten years.

FRM (Fixed-Rate Mortgage) Pros and Cons

FRM Pros:

• You can budget more easily since you know the amount of your monthly payments for the next 15 or 30 years.
• There is no possibility that the interest rate can change and suddenly make your payment unaffordable. There would not be any unpleasant shocks even if inflation boosted market rates up to 20 percent.

FRM Cons:

• You need to earn more to apply for an FRM, because the higher interest rate associated with FRMs results in a higher monthly payment.
• If market interest rates decrease significantly, you will start to lose money compared with an ARM for the same principal. In this case, you may be able to refinance to get a lower payment.

ARM (Adjustable-Rate Mortgage) Pros and Cons

ARM Pros:

• You will have a lower monthly payment because of the lower initial interest rate.
• If the interest rate drops, your monthly payments will also drop.
• Due to the lower initial interest rate and payments, it is easier to apply for ARMs.
• You can afford to buy a more expensive home if you take a low-rate ARM compared to an equivalent FRM.

ARM Cons:

• If the interest rate increases, your payment will also increase significantly. For example, a 7% ARM could rise to 11% in just three years if rates climb up.
• A large rate increase could result in you being unable to afford your mortgage payments.

Other Factors to Consider

What are the current interest rates?

When rates are high, ARMs make sense because:

• You might not be able to afford a high-rate FRM
• The rates might drop and you will then have lower payments.

When rates are relatively low, however, FRMs make more sense.

How long are you planning to stay?

If you are only going to stay at your new home for a few years, a low-rate ARM is evidently a better choice, particularly if you can get a 3/1 or 5/1 hybrid ARM. Your payment and interest rate will be low and unexpected rate hikes need not be a disaster because you can sell the house and move out before the fixed interest period ends.

How frequently does the ARM adjust?

Most ARMs adjust yearly on the day the mortgage was taken out. However, some lenders make adjustments every month. If that is too unpredictable for you then apply for an FRM.