A buyer's primer

Adjustable-rate mortgages:
One may be right for you

Anyone in the market for a house these days knows there’s a dizzying array of choices when it comes to financing. Fixed-rate, 80/20 loans, jumbos … it’s enough to send well-intentioned homebuyers running to the nearest accountant for help.

But there’s one financing option that has become very appealing to many homebuyers – especially those who know they won’t be in their home for long. The adjustable-rate mortgage, or ARM, is a type of loan whose interest rate can go up or down. By contrast, a traditional fixed-rate loan locks in your rate for the life of your loan.

That means the ARM is definitely a gamble – unlike a fixed-rate mortgage, you’ll be left guessing what your rate might be in a few years, and that’s scary. For example, an ARM that starts out around 5.75% for the first year can increase to 11.75% in the fourth year. Your monthly payment would shoot up from $581 to $1,000 (excluding taxes and insurance) – and that’s a big chunk of change.

But with an ARM, your payments are lower for the first three or four years, and will stay low as long as interest rates also stay low. And with today’s amazing lows of less than six percent, losing your left “arm,” so to speak, doesn’t have to be the case.

How ARMs work
With most ARMs, the interest rate and monthly payment change every year, every three years, or every five years. However, some ARMs have more frequent interest and payment changes. The period between one rate change and the next is called the adjustment period. So, a loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year.

Most lenders tie ARM interest-rate changes to changes in an index rate. These indexes usually go up and down with the movement of interest rates. If the index rate goes up – or down – so does your mortgage.

Lenders base ARM rates on a variety of indexes. The most common are the rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations. Ask your lender what index will be used and how often it changes, as well as its history in the past.

To determine the interest rate on an ARM, lenders add to the index rate a few percentage points called the margin. The amount of the margin can differ from one lender to another, but it is usually constant over the life of the loan.

When you compare ARMs, look at both the index and margin for each plan. Some indexes have higher average values, but they are usually used with lower margins. It can get confusing, so be sure to ask your REALTOR® or lender for advice.

Besides an overall rate ceiling, most ARMs also have caps that protect borrowers from extreme increases in monthly payments. If your ARM has a payment cap, ask about negative amortization. Negative amortization means the mortgage balance is increasing, and it happens whenever your monthly mortgage payments aren’t big enough to pay all the interest due on your mortgages.

Making an ARM work for you
With an ARM, the interest rate changes periodically, usually in relation to an index, and payments go up or down as a result. Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages, making an ARM easier on your checkbook at first than a fixed-rate mortgage for the same amount. That’s one advantage.

Another is that you might qualify for a larger loan because lenders sometimes make that decision on the basis of your current income and the first year’s payments. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage, especially if interest rates remain steady or go lower.

Another reason to consider an ARM is time. If you don’t plan to be in your home more than five years – say you’re single and want to buy a condo in a hip, urban area, yet know you plan to move in a few years to a house in the suburbs – an ARM is a great financing option.

Here are some other questions you need to ponder, if you’re considering an ARM:
- Is my income likely to rise enough to cover higher mortgage payments if interest rates go up?
- Will I be taking on other sizable debts, such as car loans or school tuition, in the near future?
- Can my payments increase even if interest rates generally do not increase?

A little common sense, a lot of research and being realistic about your housing future will help you make the best financing decision – and help you determine whether an adjustable-rate mortgage is the way to go.

Source: Federal Citizen Information Center