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Choosing A Loan – Basics Of FRM Vs ARM
When you first put in your application for the next mortgage, the next thought that comes into your mind is probably the same as everyone else. Which is whether you should opt for a fixed rate mortgage or adjustable rate mortgage. If it is the first time that you are applying or getting a loan for your house, you would also be wondering how they differ and is one preferable to the other? Which option saves more money for you? Here are some of the common answers with the advantages and disadvantages of both.
Fixed Rate Mortgage
A FRM or Fixed Rate Mortgage is basically a conventional home loan, based on an interest rate that remains unchanged throughout the term of the mortgage. Principally, your rate of interest is fixed and will stay fixed all through the time span of your mortgage. For example, if you can get a mortgage with an interest rate of 7 percent you will keep that interest rate right through the duration of your 20 – 30 year mortgage. Or whatever number of years you end up signing up for.
One unique advantage of the FRM is that homeowners are able to budget precisely for all their payments month after month. So this is great for people who love to plan out their finances over the long term as meticulously as possible. As the rate of interest remains fixed, so is the payment. This means that you can efficiently budget as also plan it without having to worry about fluctuating interest rates. You will be free from interest rate surprises and be able to sleep better at night fully free from the unknown.
Of course, the banks should bear this fixed interest rate risk, as fixed rate mortgages might at times be a little more costly for you. In a way, you will look on the surface to be paying a little extra for the certainty that it brings. For instance, any mortgage having a fixed rate of interest might carry a somewhat higher interest rate as compared to a loan with a variable rate. However, in case there is a rise in interest rates, the FRM will remain the same for all time, thus helping you save some money as an opportunity gain. Naturally, if you intend to stay in your own home for considerable lengths of time, fixed rate mortgages can be more advantageous to you. This is why more homeowners compared to investors and flippers prefer it.
Variable Rate Mortgage
A VRM or Variable Rate Mortgage, also termed a floating rate mortgage, is essentially a home loan which bases its rates of interest on factors such as the market, market conditions and federal interest rates. It may also be referred to as Adjustable Rate Mortgage (ARM) by those in the industry. Many such facilities are pegged or have a spread in addition to a public index. The London Interbank Offer Rate (LIBOR) is probably the most common index used to peg home loans against.
Every quarter or month, your interest keeps changing depending on the interest rate issued by your bank as also the federal government. Normally, your mortgage is linked directly to the rate of standard index interest. However if this condition is not mentioned in the contract, then the rate of interest can be adjusted at the discretion of lender. This give you another reason to read the terms and conditions of your contract to the letter. Make sure to clarify terms that you are unsure of with your banker or broker.
There are lenders who offer a cap-rate, signifying that a maximum percentage is set on how high the rate of interest can reach. In some parts of the world, this is also referred to as an interest rate ceiling. This is meant to offer borrowers protection against undue hardships due to soaring interest rates or economic recession.
For example, if your ceiling is 6 percent, that is the maximum you will be charged even if the economy booms causing index rates and spreads to rise above 6 percent. Many lenders incorporate this feature for borrowers into their facilities to provide that added security and sense of stability. The takeaway again, is that you will probably be charged a slight premium for this peace of mind. It is something like a mobile data plan. Even though a mobile network operator might charge $5 for any additional gigabyte of data you use, there can be a cap of $60 no matter how much data you use.
Overall, borrowers often prefer fixed rate mortgages to adjustable rate mortgages, although this is not the case always. This is because with ARMs, in case the rate of interests increase, the cost of your mortgage follows in its wake; and if on the contrary, the interest rates decrease, the opposite is true. Essentially, if the borrower has agreed to accept the risk on interest rate, it will generally result in a much lower interest rate.
But when it comes to investors with a shorter term strategy, VRMs can offer more flexibility and advantages. For example, an investor with a 3 year exit strategy for his real estate investments might find VRMs with low initial 3 year rate to perfectly suit his plans. Taking up a FRM and pay a premium for 3 short years is just an additional cost towards the bottom line.
There are many circumstances that can affect your decision on one of the 2 types of mortgages. It does not lie solely on the point of view of whether you are a homeowner or investor. Your financial and lifestyle plans over the long and short term will be the main factor that determines a suitable choice. So do draw up your personal plans before making a decision on your choice of mortgage.