Many people like the idea of adjustable rate mortgages (ARMs), but what are the risks?
A mortgage with an adjustable rate has a rate that changes based on the market interest rate. After an initial fixed period, the rate will change at a set time, like once a year. There are six-month to five-year fixed times. Some may have even longer fixed periods.
In an ARM, the risk comes from the fact that the payment can change a lot. When you have a fixed-rate mortgage, you know that your payment will be the same now, ten years from now, and twenty years from now. Since the interest rate is fixed, the payment stays the same.
When you choose an adjustable-rate mortgage, you take the chance that your payments will go up in exchange for a lower interest rate at the start. The market rate for a 30-year fixed-rate mortgage is usually much higher than this rate. The lower your interest rate is at first, the more risk you are willing to take. The risk goes up the more changes the loan will go through. Tradition says that even after a loan adjustment, the rates will still be lower than those for new 30-year fixed mortgage borrowers. But there are times when this gap is closed, especially when interest rates are going up.
When interest rates are going down is the best time to get an ARM. Even though there is risk, an ARM can be good for some borrowers. Most advisors will tell you that you should always go with a fixed-rate mortgage, but there are times when you might want to go with an adjustable rate.
- The borrower needs extra money for a while.
A lower fixed rate at the beginning of your loan gives you more money to spend early on. For example, a one-year ARM with a 30-year term and a rate that changes every year on the anniversary of the loan date has a starting rate of 5.625% and no points. Let's compare that to a 30-year loan with a fixed rate of 7.625 percent and no points.
With a 30-year fixed rate, the monthly payment on a $240,000 mortgage would be $1,698.70. The payment for the one-year ARM would be $1,381.58 per month. That's a monthly difference of $317.
You could pay off your credit cards, fix up your house, or save for retirement with that extra $317. But you want to make sure you can keep living the way you do now even if your payment goes up. You don't want to find out when the rate goes up that you can't pay a higher mortgage payment.
- Get more property.
Because the interest rate is lower at first, you can get a bigger mortgage and a more expensive home. Many people who buy homes get one-year ARMs so they can refinance them later. Because the rate is low, you can buy a more expensive home and pay less on your mortgage. But keep in mind that refinancing costs money at the end. Figure out if you are really saving money by doing the math.
- It all depends on what will happen next.
An ARM is a good choice if you want to move or upgrade in the next few years. You can take advantage of a low mortgage rate by selling the home and buying another one before the rate goes back up. For example, if you want to move in three years, you could get a five-year mortgage that you can change. As long as you sell the house during the initial rate period, you get a lower rate that won't change while you own it.
Make sure that there are no fees if you pay off the loan early. Don't forget to do some math. If interest rates go up a lot in those three years, you will have to pay the higher rates when you buy a new home. This could make it hard for you to move up to a bigger or more expensive home.
With adjustable-rate mortgages, it's all about figuring out what the risks are. You risk having to pay a lot more in the future in exchange for a lower interest rate and payment now. Some homeowners are going through this right now, as the number of foreclosures is going up. Many people didn't figure out how much their mortgages could go up or down. Some people have seen big price increases that they can't pay for. Do all of the math and always prepare for the worst case scenario when considering an adjustable rate mortgage.
