What You Should Consider While Shopping for an Adjustable Mortgage

The interest rate on an adjustable mortgage (ARM) can change at every adjustment. Actually, this is the main difference between a fixed rate mortgage and an adjustable mortgage. ARMs are also called flexible rate mortgages.

All adjustable mortgages have an initial period during which the rate of interest is lower than fixed rates. In fact, these low initial rates are the biggest USP of ARMs. They make mortgage payments affordable, at least during the initial period. But things can change for the worse when the rates adjust after the initial period.

Advantages of adjustable mortgages

·         Interest rates are low during the initial period. In fact, the rates on an ARM can be lower than fixed rates by 2 – 3%. This will translate into significant savings for the borrower.

·         Getting an ARM is easier than getting a fixed-rate mortgage.

·         Payments can drop if index rates fall.

·         Processing times are quicker and lenders are more willing to offer ARMs.

·         Most ARMs do not have a prepayment penalty.

Drawbacks

Monthly mortgage payments can increase when interest rates rise. On the other hand, when you have a fixed-rate mortgage, you are immune to rate changes.

There is the risk of negative amortization. Adjustable mortgages have rate and payment caps. That means your monthly payment can't go beyond a certain amount. As a result, sometimes your payment may not cover the whole of the interest costs. In this case, the difference will be added to the principal amount. If this happens even after making several mortgage payments, you will still owe more money than you did when took the loan.

Who should consider getting an ARM?

People who are purchasing a starter home should consider getting an ARM because they are more likely to sell that home and move into a bigger home during the initial period itself.

People who are likely to get a transfer in the next two - three years also make good candidates for ARM.

Who should not consider getting an ARM?

Homeowners who plan to live in the same house for the rest of their life should consider getting a fixed rate mortgage, not an adjustable mortgage.

People who don't expect their income to increase in the immediate future, too, should not get an ARM.

While shopping for an ARM, you should ask the following questions to the lender.

·         What is the initial interest rate?

·         What is the annual percentage rate?

·         What index does the lender use to adjust the loan? The borrower should also ask how this index performed over the last few years.

·         What is the lender's margin? (The lender will add margin to the index rate to calculate the ARM interest rate. The margin will be the same throughout the life of your loan.)

·         How long does the initial period last?

·         Will the rate go up at the first adjustment even if the benchmark index hasn't moved?

·         Is there a rate cap?

·         How often will the rate change?

·         Does the mortgage require private insurance? If so, how much will it cost?

·         Is there a prepayment penalty?

·         Does the loan carry the risk of negative amortization?

Getting an ARM is not a wise idea if you intend to get an educational or an auto loan in the future.