Should I Use An Adjustable Rate Mortgage To Finance My Home?

When you purchase or refinance your home, in your quest to find the best mortgage rates, you may may be offered an adjustable rate mortgage as an option to a fixed rate mortgage.

Your mortgage officer may suggest an adjustable rate because the initial interest rate will be lower, making the monthly payment lower than a comparable fixed rate mortgage.

But while you have the lower monthly payment, which can be very attractive, realize an ARM's interest rate can change either up or down.

What Is An Adjustable Rate Mortgage?

An adjustable rate mortgage can also be called a variable rate mortgage or go by its acronym....ARM.

An adjustable rate mortgage will adjust periodically at predetermined intervals. The adjustment will be based on a financial index. The most common is the 1 year Treasury or the LIBOR index (London Interbank Offered Rate). If the index rises your mortgage rate rises, If the index lowers your mortgage rate will be lower.

Because you are taking some risk from the bank, an ARM will typically be lower than a 30 year fixed.

What To Look For With An ARM

If you are considering using an adjustable rate mortgage to finance or refinance your home there are several variables to look at when making the decision.

1. Index Rate- The initial rate of the index being used for your ARM mortgage. If your index goes up your mortgage rate will rise, if your index goes down your interest rate will lower, all based on the index used.
2. Margin- The margin is the difference between the index and what you are being charged for an interest rate. A typical margin could be between 1.5 to 2.50%
3. Initial Rate Adjustment Period- The initial period that your loan will remain fixed. Right now you can find 3, 5, 7 or 10 year periods for the initial fixed rate.
4. Subsequent Rate Adjustment Period- How often the rate can adjust after the initial rate adjustment period. Most often it is one year.
5. Initial Rate Adjustment Cap- This is the cap the rate can adjust on the first rate adjustment. The initial adjustment cap is usually higher than the subsequent and could be up to 5 or 6%
6. Subsequent Adjustment Cap- This is for all additional adjustment periods and is usually capped around 2%
7. Lifetime Cap- The maximum adjustment that can be made over the life of the loan. The lifetime cap is often around 6%

So lets just look at it quick. Worse case 5/1 ARM might be around 3.75% and would carry a lifetime cap of 9.75%. It could adjust up to 8.75% on the 6th year. If you haven't capped out it could adjust up to 2% a year.

Realistically, in the past 5 years the 5 year ARM has been at a low of about 2.5% and a high of about 4.5%. On a $400,000 loan from worst case to best case there would be a $447 dollar a month difference in mortgage payment.

Should I Use An Adjustable Rate Mortgage?

Whether you should use an adjustable rate mortgage or not is a very personal decision. You should take into account your tolerance for risk as well as can you afford the mortgage if the worse case scenario should happen.

An adjustable rate mortgage can be a good mortgage for:

• A borrower knowing they are buying for the short term. Many relocation buyers are on assignment for 3-7 years and know they want to move back to where they are coming from.
• A high net worth individual who knows they can earn more interest with their money than what they are paying in interest on a mortgage.
• Someone who knows there financial future is going to change for the better in the near future. A doctor finishing up residency would be a great example.

An adjustable rate mortgage could be a bad mortgage for:

• A borrower using an ARM to qualify with a lower rate because they can't qualify with a 30 year fixed.
• A borrower who cannot handle the risk tolerance of a significant rise in mortgage payment.

Final Thoughts On Using An ARM To Finance Your Home

There are certainly times where an adjustable rate mortgage makes sense for the right borrower. An ARM should never be used to squeak by qualifying for the loan, or because the loan payment is already burdensome and your looking to save a few bucks.

When shopping for a mortgage and looking at your mortgage options , remember adjustable rate mortgages has variables. Make sure you are comparing apples to apples.