Tutorial on Choosing Between ARMs and FRMs

18 April 2006, Revised November 12, 2008, August 21, 2011

In general, ARMs have lower payments in the early years than FRMs but expose you to the risk of higher payments in future years.

Select an FRM if you can afford the payment, and a) expect to have the mortgage 7 years or longer, or b) have a strong preference for payment stability. Select an ARM if you cannot afford the payment on an FRM, or if you confidently expect to be out of the house within 7 years.

If you might be out of your house within 7 years but aren’t sure, the decision process is more difficult. In assessing it, you must balance the rate savings on the ARM relative to an FRM during the initial rate period of the ARM, with the risk of rate increases when the initial rate period ends – if it turns out that you still have the mortgage at that point. The rate saving is the FRM rate less the ARM rate at about the same number of points.

You can quantify the risk of rate increases after the initial rate period ends with calculator 7b (Monthly Payment Calculator: Adjustable-Rate Mortgages Without Negative Amortization.) For your ARM, you must know the current value of the index, margin, rate adjustment cap, and maximum rate. You must also specify an assumption about what happens to interest rates. The calculator will give you several options, including the “worst case” possible. The worst case has a very low probability of occurrence, but it is nice to know you could manage it. For a detailed illustration of a comparison, see Choosing Between Fixed and Adjustable Rate Mortgages.

The professor's loan network will simplify the decision process by allowing you to compare the total cost of all mortgage options over your  time horizon. The figure for ARMs will be based on the assumption that interest rates do not change. The risk inherent in the ARMs will be measured by the "worst case" rate and payment, and the month it would be reached.

You can also check out a strategy used by some astute borrowers, which is to take an ARM but make the payment that they would have made had they taken an FRM. By paying the ARM balance down faster, the cost imposed by rising rates in the future, if you still have the mortgage, is reduced. You can check out an ARM using this strategy at ARM Tables Tutorial.

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