Opting for an Adjustable-Rate Mortgage
By Mark Nash
- Adjustable-rate mortgages (ARMs) in today’s market
- Knowing if an ARM is right for you
- ARM pitfalls and other things to consider
By now, you’ve heard plenty about the housing credit crises spurred by a high number of defaults on adjustable-rate mortgages (ARMs), notoriously known as “subprime mortgages.” These mortgages were given to low-income borrowers with subprime credit ratings, causing many of these folks to foreclose on their homes. Due to this current crunch, ARMs have become less appealing and available. And with today’s falling interest rates, fixed-rate mortgages are the way to go. Still, you should know about ARMs to see if they are a viable financing option for your home purchase, if not now, then in the future.
An ARM is a mortgage loan that has an interest rate that periodically changes or adjusts. The rate can remain static for an initial term — called a “teaser period” — and then it adjusts annually, based on various economic indexes. The initial, or teaser, rate may last anywhere between one to several years. And here’s where the risk-taking aspect of ARMs comes in: Interest rates can go down, but they also can go way up — which has been the case recently and the reason why many homeowners with ARMS have had a tough time meeting their monthly payments.
ARMs have caps or limits on how much the interest can rise with each adjustment, as well as an overall cap over the term of the loan. The caps are an important area to consider before you sign a mortgage note. You might easily qualify for the introductory interest rate, but with the first or several subsequent adjustments, your payments may become unaffordable.
When ARMs work
ARMs are a good idea if their initial interest-rate is more than 1 percent lower than that of a fixed-rate mortgage. Also, if you only plan to be in the home for only several years or a shorter time before the first rate adjustment, the lower rate in the teaser period may significantly decrease your monthly payments — something a fixed-rate mortgage wouldn’t do. On the other hand, if the going rate on a fixed-rate mortgage is only 0.15% higher than an ARM, you’re better off with a fixed.
Some first-time buyers like ARMs, because their loan payments grow as their income does. If you know that a job promotion is coming or you’ll be receiving a large gift or inheritance, an ARM may be a good loan to help you jump into homeownership and then transition financially in steps as your income increases. On the other hand, if you’re not a risk-taker and will lose sleep worrying if your rate will adjust higher, then get a predictable fixed-rate.
Not all ARM’s are equal. You have to be well aware of their ups and downs. Never agree to a prepayment penalty, this locks you into the attractive rate, typically, until it readjusts to a higher one. Prepayment penalties can be steep, and if for some reason you have to sell, the penalty can wreak havoc with the equity you’ve built up in your home. Also, ask how much the maximum interest-rate caps are.
Keep in mind that your first adjustment typically occurs after one, three or five years. After the initial adjustment, it could reset as frequently as every year. The adjustments are tied to financial indexes, which you can’t control. So if you want peace of mind, you’re better off with a fixed-rate mortgage than a riskier ARM.
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