Fixed Rate Mortgage and Adjustable Rate Mortgage - Essay Example

Curse FRM and ARM Introduction Purchasers of real property often do not have the entire fund available with them to buy a real estate property. In such cases, people go for some amount of down payment or cash payment for the property. Rest of the amount they borrow. When the money is borrowed from a lender, the lender actually faces risk and associated opportunity cost. Opportunity cost comes into picture because the money that the lender lends to the borrower could be used by him on some other purposes. To make up for this opportunity cost he charges interest from the borrower. The risk that the lender faces is the fear of nonpayment of the loan amount by the borrower. To mitigate this risk a mortgage on the property or the real asset is created. Through the mortgage the borrower or the mortgagor pledges the real property to the mortgagee or the lender as a security against the debt. The report below discusses two types of mortgages that differ from each other in terms of interest rate. That is one is fixed rate mortgage and the other is variable or floating or adjustable rate mortgage. Discussion The mortgage creates a legal title in favor of the mortgagee or the lender and an equitable title in favor of the mortgagor or the borrower. The legal title however does not entitle the mortgagee to enjoy the property. The lender can exercise his rights only if the borrower defaults in his payments or does not abide by the terms of mortgage. A mortgage consists of two parts. 1. The pledge or the mortgage. 2. Provisory note by which the borrower agrees to have taken the loan amount and promises to pay back the same after the required period. To secure the interest of mortgagor the mortgage information is entered into public records. When giving a loan on a property as a mortgage, the lender runs a title search through the public record books in order to find out whether other mortgage already exists on the particular asset or not. On the basis of interest rate there are two types of mortgage Fixed rate mortgage and Adjustable rate or floating rate or variable rate mortgage. What are FRM and ARM Fixed rate mortgage or the vanilla wafer mortgage is a type of mortgage where the interest rate on the mortgage remains same throughout the term of mortgage. Since the rate of interest remains constant during the period of the loan, the amount of money that the borrower has to pay as interest remains constant throughout the loan period. Thus in FRM the borrower knows with certainty the amount of interest he has to pay as loan periodically and thus can plan his budget accordingly in advance. In fixed rate mortgage the rate of interest is advertised by the bank. Fixed rate mortgages are not only popular but their main benefit is that they are very predictable. The fixed rate mortgage comes with various associated periods but the most popular are 15 year and 30 year period. Fixed rate mortgages are generally more costly than the Adjustable rate mortgage. Fixed rate mortgage are characterized by higher initial interest rate as compared to floating rate. However over long term perspective it may turn out that FRM is cheaper as compared to ARM. Usually it is found that longer is the period of the mortgage higher is the interest rate of FRM. This is exemplified by a positive and upward sloping yield curve. ARM or adjustable rate mortgage is a type of mortgage where the interest rate of the loan amount changes periodically reflecting on the change of a certain interest rate to which it is pegged. The loan given out by mortgagee to the mortgagor may either be the base rate or the lender may choose to add certain percentage on the base rate. The base rate may either be a standard one like LIBOR (London Interbank Offered rate), COFI (Cost OF Funds Index) etc. or in certain cases the base rate may be determined by the lending bank themselves. Whatever be the case the interest rate varies in accordance with the change of the chosen base rate. This type of mortgage poses a risk to the borrower in terms of financial hurdle in the form of sudden jump in interest rate likely to be faced by him. Main difference between FRM and ARM The FRM is characterized by fixed rate of interest. The mortgagor has to pay a uniform rate of interest throughout the mortgage period (Davidson, Sanders, Wolff, and Ching 54). The interest rate that the mortgagor has to pay is decided mutually by the mortgagor and the mortgagee at the initial period and the rate remains constant through the period of mortgage. The Fixed rate mortgage is very popular in the United States. Fixed rate mortgages are available for various periods but the most popular are 15 year and 30 year period. The relation between short term and the long term interest rates is represented by yield curve. It is seen that the yield curve is upward sloping. That is interest rate for longer terms is greater that the interest rate for shorter terms. There is a risk return relationship that comes into play when deciding between FRM and ARM. In FRM it is found that the initial rate of interest is normally higher. But the added benefit that comes attached is that the borrower does not have to live in constant financial threat of fluctuation on interest rate. The fixed monthly payment of a FRM is given by the formula. C= (r/ (1-(1+r)-N)) p0 The variation of Fixed rate of interest for a FRM over the years is given shows that the trend is decreasing one. Figure 1: Fixed rate Mortgage interest rate over the years (Reckard) As compared to FRM, ARM comes with a variable interest rate (Leonard 4). The variable interest rate is determined either by standard base rate or by adding a percent to the base rate. In case of ARM the borrower or the mortgagor has to live in the threat of facing increased rate of interest any time. The particular problem with ARM is that the borrower is not sure the amount of interest he has to pay every month. However to protect the borrower several caps have been put like a cap on the maximum rate change and no. of times rate can change. Main factors needed to be considered while choosing between ARM and FRM There are several factors that need to be considered before choosing between whether the borrower should go in for Adjustable rate mortgage or Fixed rate mortgage. In case of fixed rate mortgage the starting rate of interest is generally higher as compared to the adjustable rate mortgage. However this does not mean that one should never choose fixed rate mortgage and always go for adjusted rate or floating rate mortgage. Both the mortgages in fact come with associated risk. If the borrower goes in for fixed rate of mortgage he is sure of the amount of interest he has to pay ever month but may be on a losing side if the interest rate decreases in future. Similarly the individual who has gone for floating rate interest may have to bear lower rate of interest initially but does not know if the interest rates are going to rise in the longer term in which case he will be a loser. Normally the borrowers who have gone for ARM have saved money in the longer term but there have been certain exceptions. In fact choosing between the two mortgages will require careful deliberations and thoughts on several factors such as risk taking ability, current rate of interest and the probability that the interest rate will rise in future. There is an additional feature that needs to be looked at while choosing between ARM and FRM. ARM has the advantage that the borrower can reduce his loan amount by paying a lump sum at a time. But in case of FRM there is a restriction to the amount of lump sum that one can pay at a time and paying more than that attracts a charge. Figure 2: ARM Trend (Andriotis, Anna Maria and Shayndi Raice) Conclusion Mortgage is used as a financing scheme to acquire an asset when the total cost of an asset is very high and the purchaser cannot afford the entire amount. In such cases the purchaser pays some initial amount towards acquisition as down payment. For rest of the amount he takes a loan. For taking the loan he has to keep the real asset as mortgage. By the process of mortgage the legal title of the property passes on to the lender and the equitable title to the property remains with the borrower. The lender can exercise his rights only if the borrower fails to pay back the money. There are two types of mortgage on the basis of interest rate FFRM and ARM. Both of this type comes associated with risk and reward as has been discussed in the report. The borrower needs to judge several factors before choosing a particular one out of the two. References Andriotis, Anna Maria and Shayndi Raice. Adjustable-rate mortgages make a comeback. March 16, 2014. < http://online.wsj.com/articles/SB10001424052702303546204579439171591130740>. Davidson, Andrew, Anthony Sanders, Lan-Ling Wolff, and Anne Ching. Securitization: structuring and investment analysis. New Jersey: John Wiley & Sons, 2004. Print Leonard, Barry. Consumer handbook on adjustable-rate mortgages. Darby: DIANE Publishing, 2007. Print Scott Reckard. Fixed mortgage rates ease, Freddie Mac says; 30-year at 4.51%. August 29. 2013. Web. 25 November 2014. . Read More