Mortgage Comparison
Fixed-Rate vs Adjustable-Rate Mortgage
Fixed-rate mortgages offer payment stability; ARMs offer lower initial rates with future adjustment risk. The exam tests ARM mechanics — indexes, margins, caps, and teaser rates.
Fixed-Rate vs ARM: Key Differences
Fixed-Rate Mortgage
Interest rate stays the same for the entire loan term (15 or 30 years). Principal and interest payment never changes. Best when rates are low or the buyer plans to stay long-term.
Adjustable-Rate Mortgage (ARM)
Interest rate is fixed for an initial period, then adjusts periodically based on a market index. Lower initial rate may rise significantly. Best when rates are high or the buyer plans to move or refinance before adjustment.
ARM Key Terms for the Exam
Index
The benchmark interest rate used to calculate ARM adjustments. Common indexes include SOFR (Secured Overnight Financing Rate — replaced LIBOR) and the 1-Year Treasury CMT.
Margin
A fixed percentage added to the index to calculate the ARM's interest rate. Example: index (3.5%) + margin (2.5%) = rate (6%). The margin does not change.
Teaser Rate
An artificially low initial interest rate. The rate adjusts to index + margin after the initial fixed period. A common source of payment shock.
Adjustment Caps
Limits on how much the interest rate can change at each adjustment period. A 2% periodic cap means the rate cannot rise more than 2% per adjustment.
Lifetime Cap
The maximum amount the interest rate can increase over the life of the loan. A 5% lifetime cap means a 4% teaser rate cannot rise above 9%.
Negative Amortization
Occurs when the monthly payment is less than the interest owed, causing the unpaid interest to be added to the loan balance. The borrower owes more than they originally borrowed.
ARM FAQ for the Exam
What does '5/1 ARM' mean?
The first number (5) is the initial fixed-rate period in years. The second number (1) is how often the rate adjusts after that — every 1 year. A 5/1 ARM has a fixed rate for 5 years, then adjusts annually.
What is negative amortization and why is it risky?
Negative amortization occurs when the monthly payment doesn't cover the interest owed. Unpaid interest is added to the principal balance — the borrower owes more than they borrowed. If property values fall while the balance grows, the borrower can end up severely underwater.