Ahmed Al-Qatrawi

Accounting Department
Al Azhar University

What is the difference between a

fixed-rate and adjustable-rate
mortgage (ARM) loan?
The difference between a fixed rate and an adjustable
rate mortgage is that, for fixed rates the interest rate is
set when you take out the loan and will not change. With
an adjustable rate mortgage, the interest rate may go up
or down. 
A fixed-rate mortgage is exactly what it sounds like. It’s a mortgage that keeps
the same rate for the entire life of the loan, typically 15- or 30-year terms. So
let’s say you take out a 30-year fixed-rate mortgage with a $2000 monthly
payment this year. You’ll still be making that same payment of principal and
interest 10, 20 and 30 years down the line.

In an adjustable-rate mortgage, These mortgages have interest rates that

can change depending on market conditions, meaning that your monthly
payment can go up or down. The most popular type of ARM taken out today is
a fixed-period ARM, also known as a hybrid ARM. They’re based on a 30-year
term and typically start with an initial fixed-interest rate for a specific period of
time, usually 5, 7 or 10 years. For example, a five-year ARM will be referred to
as a 5/1 ARM, and its interest rate will stay the same for the first five years.
Because the interest stays the same for five years, the monthly payment of
principal and interest will also stay the same for this time period. But after that
fifth year, the interest rate is subject to change annually for the remaining 25
years left on the mortgage. The rate will change based upon changes in the
current financial market, and that means that your monthly payments will
change based on the interest rate applicable at the time of adjustment. So
make sure that you’re prepared to make higher monthly payments if interest
rates rise.
 Comparison chart

Adjustable Rate Fixed Rate Mortgage

Mortgage
Interest rate Fixed for the first few
years, resets periodically
thereafter
Interest rate risk The risk of interest rates
rising in the market is
borne by the borrower. If
rates fall, borrower
benefits.
Affordability Monthly payments are
lower initially (for the first higher because interest
few years)
Fixed for the duration of
the loan
The risk of interest rates
rising is borne by the
lender. If interest rates fall,
borrower may refinance
but usually incurs
prepayment fees or other
costs associated.
Monthly payments are
rate is slightly higher;
because the lender
bears the interest rate
risk and charges the
borrower a premium for
this risk.

Key differences between fixed rate loans and ARM

In a fixed rate mortgage, the interest rate the bank charges the
borrower remains the same throughout the entire duration of the loan
(usually 15 to 30 years). On the other hand, interest rate on an
adjustable-rate mortgage (ARM) is reset periodically (usually every
year after an initial period of 2,3 or 5 years). A 3/1 ARM means that the
interest rate on the loan is fixed for the first 3 years but changes after
that once a year until the loan is repaid. Lenders usually aren't allowed
to raise interest rates on ARM arbitrarily. When the interest rate on an
ARM is reset, it is determined by using a benchmark market rate
e.g. LIBOR.
With a long-term fixed-rate mortgage, the lender assumes the interest
rate risk i.e. the risk that interest rates will rise in the future. Therefore,

 Longer term fixed-rate mortgages are more expensive i.e. interest

rate on a 30-year fixed-rate loan will be higher than a 15-year fixed-
rate mortgage
 Initial interest rate on ARM is lower than any fixed-rate mortage
i.e. interest rate for the first 5 years on a 5/1 ARM will be lower than
the interest rate on a 15-year fixed-rate mortgage. So monthly
payments will be lower with ARM loans initially.
 Risk
The risk with an ARM is that the rate of interest (and therefore, monthly
payments) may rise over the lifetime of the loan. The low interest rates
on ARM may not last beyond the initial period. So when interest rates
are low, it may be tempting to lock them in with a fixed-rate mortgage.
Correspondingly, the risk with a fixed-rate mortgage is that interest
rates may either fall or stay low for an extended duration. While a
borrower can usually refinance to take advantage of lower interest
rates, sometimes there is a prepayment penalty for closing out the
loan; and there is always fees (closing costs, appraisal fee etc.)
associated with refinancing.

Pros and Cons

With a fixed rate mortgage loan, you can be certain of the amount you
owe the bank on a monthly basis. It remains the same through the
entire term of your loan, never stressing you out if there is a fluctuation
in the market. A variable rate mortgage on the other hand, gives you
the option to pay less interest, if the market conditions are favorable.
Also, some lenders usually put a cap to the highest interest rate that
can be charged. In this way, you are assured of paying moderate
rates. Due to lower monthly payments (at least in the first few years),
ARMs are more affordable.

How to choose
Here are some tips to choose which mortgage to take:

 If interest rates are already very low and unlikely to go much

lower, choose a fixed rate mortgage and lock in your interest rate.
 If you expect to repay a substantial portion of the principle in the
early years, choose an adjustable rate mortgage. e.g. You take a
$300,000 loan but are planning to repay $60,000 (as extra payments;
over and above your monthly payments) in the first 3 years.
 If the lower interest rate on the ARM allows you to buy the home
but the fixed-rate would raise monthly premiums too high, then be
careful. Only take the ARM loan if you expect your income to rise in
the future, because if your income does not rise and the interest rate
resets higher after the initial period, then you will no longer be able to
afford to make your payments.
 Always try and choose loans that do not have a prepayment
penalty. This gives you more flexibility to refinance if interest rates fall.
.

Conclusion
A key factor is time. How long will you be in this house? If you’re likely to
move within a few years or you’re flipping an investment property, an
adjustable-rate may make sense for you. You’ll likely be selling before the
initial interest rate period ends.
If you’re looking for a family home to hold on to for a while, a fixed rate
would offer the long-term stability you need. Depending on economic shifts,
you may even find a fixed-rate mortgage with a lower interest rate than
some adjustable-rate mortgages. Even with a higher initial monthly
payment, fixed-rate mortgages are considered a safe bet due to their set
rates.  

when it comes to buying a home, whether now or in the future, it’s

important to know the ins and outs of getting the right mortgage. What’s
more, you need to have your financial house in order before you get started,
so work out a budget. Look up current interest rates. Run some numbers
using an online mortgage calculator. And be sure to be honest with yourself
about how much home you can really afford. Because you’re not only
setting out the welcome mat for a happy home, you’re making a financial
commitment for many years to come.