The Differences Between A Fixed Rate Loan and An Adjustable Rate Loan



Choosing a mortgage can be very stressful and confusing. This article aims to outline some basic information regarding the differences between fixed-rate and adjustable-rate loans but it’s always a good idea to speak to a Sacramento home loans company for specifics regarding your situation.

Fixed Rate Mortgage

With a fixed rate mortgage, the monthly payment is the same for the entire mortgage term, as the interest rate does not change. The monthly payment is calculated as what must be paid in order to completely pay back the loan in a certain number of years, typically 15 or 30. In some cases there is what is called a “balloon payment” at the end of the loan. A balloon payment is a final, large payment that covers the remaining balance. The state of California requires that a notice is sent to the loan-holder that a balloon payment is approaching and that the loan-holder may refinance this payment.

Initially, each monthly payment is mostly covering interest. The portion of the monthly payment allocated to the actual loan amount increases as time goes on, and the amount of interest paid gradually decreases. This is because as soon as you pay back any amount of the actual loan, the amount on which the interest is calculated has decreased. While property taxes and homeowners insurance my increase over time, the loan payment will vary insubstantially.

Choosing a fixed-rate loan ensures that you will be paying the same interest rate throughout the life of the loan. This can be nice as the monthly bill can always be anticipated. It is wise to choose a fixed-rate loan if the interest rate is low. Homeowners with adjustable-rate mortgages can refinance to a fixed-rate loan to provide greater stability in monthly payments. Speak to a Sacramento home loans company for more details pertaining to your situation.

Adjustable Rate Mortgage

An adjustable rate mortgage (ARM) is a loan in which the interest rate fluctuates according to the interest rates in the economy. Typically, ARM loans have an initial interest rate that is lower than that of fixed rate loans as a sort of “teaser” for the loan-holder. After the initial discounts expire, the mortgage rate will fluctuate as general interest rates increase and decrease.

Different ARMs are connected to different financial markets, so interest rate fluctuations vary across ARMs. Some mortgages may have interest rates that are tied to more volatile markets, so their rates fluctuate more rapidly. The most common financial indexes on which an ARM in the state of California may be based are:

  • The Treasury Average
  • 1 year rate on Treasury Securities
  • The LIBOR (London Interbank Offered Rate, or the rate at which banks are offering loans to each other)
  • The Prime Lending Rate
  • COFI (the 11th District Cost of Funds Index)

In order to avoid constant and severe changes, many ARMs cap how much and how frequently interest rate or payments can change in a single year and in total over the entire life of the loan.

In addition to the rate of the financial index to which an ARM is tied, there is an additional rate that is added on top of the index rate for a fully-indexed rate, called a margin. A margin varies between loan-holders, usually ranging from 2.00% to 2.75%. The exact value of a margin depends on the index used, specifics of the loan application (e.g. credit score), the loan size as relating to the property value, etc.

There are a variety of ARM structures so it’s best to speak to a Sacramento home loans company for more information. Some mortgages start as fixed-rate and then switch to adjustable-rate after a specified number of years. There are ARMs that have monthly payments that are interest-only, principal plus interest, minimum payment, and accelerated payment. Option ARMs give the loan-holder the option of paying the minimum amount, an interest-only amount, the typical principal plus interest amount, or an accelerated amount each month. This gives the loan-holder a lot of flexibility in the manner in which the loan is repaid. While this is most advantageous for individuals with lower incomes, it may be difficult for these people to get them, especially given the recent credit crisis.

Many borrowers choose an ARM because the initial rate is low and they plan to sell the home before the adjustable rate kicks in. This can be a risky strategy, especially if property values decrease and it becomes difficult to sell the home or refinance the loan.

Call a Sacramento Home Loans Company Today for Information Regarding Your Loans

The Sunrise Vista Mortgage Team is your premier mortgage team in northern California. We are committed to providing you with the highest quality financial services. Give us a call today at (916) 729-2000 to speak to a top Sacramento home loans company.