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WalletPrep worksheet · Housing

Should you get a fixed-rate or adjustable-rate mortgage?

Name ____________________ Date __________

Key ideas

  1. A fixed rate never changes for the loan's life. Your principal and interest payment stays the same every month. Taxes and insurance in escrow can still move.
  2. An ARM rate equals index plus margin. After the starting period, the rate resets to a market index plus a set margin, limited by caps.
  3. Test the worst-case payment before you sign. Ask the lender for the highest payment the caps allow. If it would not fit your budget, choose fixed.

Vocabulary

Principal
The amount you borrowed, or the part of your balance that is still owed, not counting interest.
Adjustable-rate mortgage
A mortgage whose interest rate is fixed for a starting period, then changes on a schedule based on a market index plus a margin.
Rate cap
A limit on how much an adjustable-rate mortgage's interest rate can change at one adjustment or over the life of the loan.
Loan Estimate
A standard three-page form a lender must give you within three business days of a mortgage application, showing the rate, payment and closing costs.
Escrow account
An account your mortgage servicer uses to collect part of each payment and pay your property taxes and homeowners insurance for you.
Refinancing
Replacing an existing loan with a new one, usually to get a lower interest rate, a lower payment or a different term.

Work it out

Dana is borrowing $320,000. A lender offers a 30-year fixed at 6.5% or a 5/1 ARM at 5.75% with 2/2/5 caps. The rates are made up for the example.

  1. Fixed payment at 6.5%
  2. ARM payment at 5.75%
  3. ARM saves per month, years 1 to 5
  4. Months at the starting rate
  5. Saved over 5 years
  6. ARM payment in year 6 at 7.75%
  7. Fixed payment
  8. ARM costs more per month
  9. Worst case at the 10.75% cap

Check yourself

  1. In a 5/1 ARM, what does the 5 mean?

    • A. The rate can rise 5 points in total
    • B. The starting rate lasts 5 years
    • C. The loan lasts 5 years
    • D. The margin is 5%

  2. An ARM starts at 6% with a 5-point lifetime cap. What is the highest rate it can ever reach?

    • A. 8%
    • B. 10%
    • C. 11%
    • D. There is no limit

  3. Which part of your monthly payment can change even on a fixed-rate mortgage?

    • A. The interest rate
    • B. The principal and interest payment
    • C. The loan term
    • D. Property taxes and insurance in escrow

Your turn

Put your loan amount into the mortgage calculator twice: once at a fixed rate, and once at an ARM's starting rate plus its lifetime cap. If the worst-case payment would not fit your budget, cross the ARM off your list.

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Answer key

Should you get a fixed-rate or adjustable-rate mortgage?

Work it out

  1. Fixed payment at 6.5%$2,022.62
  2. ARM payment at 5.75%− $1,867.43
  3. ARM saves per month, years 1 to 5= $155.19
  4. Months at the starting rate60
  5. Saved over 5 years$9,311
  6. ARM payment in year 6 at 7.75%$2,242.11
  7. Fixed payment− $2,022.62
  8. ARM costs more per month= $219.49
  9. Worst case at the 10.75% cap$2,855.87
  1. For 5 years the ARM saves $2,022.62 − $1,867.43 = $155.19 a month. Over 60 months that is $155.19 × 60 = $9,311.
  2. After 5 years Dana still owes $296,839. If the rate jumps the full 2 points to 7.75%, her payment on that balance over 25 years becomes $2,242.11.
  3. That is $219.49 more than the fixed payment every month. At the 10.75% lifetime cap it would be $2,855.87, so Dana picks the ARM only if $2,856 fits.

Check yourself

  1. B. The starting rate lasts 5 years The first number is how many years the starting rate holds. The 1 means it adjusts once a year after that.
  2. C. 11% The lifetime cap is measured from the starting rate: 6% + 5 points = 11%.
  3. D. Property taxes and insurance in escrow The fixed rate locks the loan payment. Taxes and insurance collected through escrow can go up or down each year.