Consider Adjustable Rate Mortgages as an Option

With rates as low as they are, why would I ever consider taking an adjustable rate mortgage?

This is a question I am asked almost daily, in the next couple minutes as you read this I wish to help you understand why adjustable rates are valid options for many Americans.  We have to first provide some structure and some historical background for context to this discussion.  The average loan right now last less than 4.5 years and we are living in our homes less than 7 years.  Yet we hold this fear that we have allowed the media to continue to spread that if we do anything other than a fixed rate mortgage we will lose our home.  I am suggesting for some there may be a better way, if we will slow down and think for ourselves we will be make educated decisions, rather than guess.

In every country besides the United States of America adjustable rate mortgage is the norm.  We are the only country that has a system (Fannie Mae / Freddie Mac) that allows for a fixed rate mortgage.

That being said lets walk through with what is an Adjustable Rate Mortgage (ARM).  ARMs as defined by multiple sources are mortgage loans where the interest rate on the note is periodically adjusted based on a variety of elements.  The interest rate, and your payments, is periodically adjusted up or down as the index changes do to the economy or other outside influences.  Those elements are the index it is based off of, the margin the banks charges and the interest rate caps associated with each loan.

ARM Indexes

While you can’t dictate which index a lender uses, you can choose a loan and lender based on the index that will apply to the loan. Ask the lender how each index used has performed in the past. Your goal is to find an ARM that is linked to an index that has remained fairly stable over many years.

Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).   When you are comparing lenders, consider both the index and the margin being offered.

It is easy to track the historical average of any index you are being quoted, don’t just take the word of the loan officer.  Go to google.com, type in history average for xyz index and you will get all kinds of information.

Margin

Think of the margin as the lender’s markup. It is an interest rate that represents the lender’s cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. The margin stays the same during the life of your home loan.

Interest Rate Caps

Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.  Periodic caps limit the amount your interest rate can increase from one adjustment period to the next.  Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.

Okay now we have some context for what is an ARM and how they move, lets me answer the question we started with, “If my payments can go up, why should I take out an ARM?”

The initial interest rate for an ARM is lower than that of a fixed rate mortgage, where the interest rate remains the same during the life of the loan. A lower rate means lower payments, which your payment will be cheaper for the same amount financed; providing you with additional financial stability.

Let me asked a question that most of us do not slow down enough to think about, how long do you plan to own this house? Rate increases in the future whatever the possibility are not as much of a factor if you plan to sell the home within in the next few years.

Are there other lift changing events that may happen in the next few years? Do you expect your income to increase? If so, the extra funds might cover the higher payments that result from rate increases or you may decide to buy a different home.  As well there are additional questions you need to ask yourself and ask your lender to decide if it is a valid option for you or not.

The Bottom Line

Do not be afraid to explore all of your options, do not use an ARM to buy more house than you can afford.  That is exactly the wrong reason to take out this type of loan. This is what led to some of the financial troubles our country has been involved in.  Some Lenders and Realtors will give you that idea; it makes them more money the more you borrow.  Take the monthly payment savings and invest it or apply it as additional principal payments.  Use these programs to financially benefit yourself and your family.