With rates rising somewhat over the past few months, many borrowers have inquired about Adjustable Rate Mortgages, which offer lower rates than the 30 year fixed products . Here, I’ll discuss the advantages and pitfalls of ARM’s.
What are the advantages of an ARM compared to a fixed rate? The single advantage of an ARM is that the rate is lower than that of a fixed rate product, and results in a lower payment.
How about the downside? The downside is the “adjustable”, which means that your rate can change at some point down the road, potentially increasing your payment.
When does the rate change? This depends on the type of ARM you select. A 5/1 ARM has a rate that is fixed for 5 years and then changes annually for the rest of the life of the loan. A 7/1 ARM has a rate that is fixed for 7 years and then changes annually.
How much can the rate change on my ARM? This is where you must get specific information on the product you are selecting, since ARM’s can differ in this regard. Accompanying an ARM disclosure are the terms 5/2/5, or 6/2/6, etc. The first number is the maximum amount the rate can change the first time it changes, after the fixed rate time is up. The second number is the maximum amount (up or down) the loan can adjust each period after the initial adjustment. The final number is the lifetime cap, telling you the maximum amount the rate can adjust above the start rate, for the life of the loan.
How do I know if an ARM is the right product for me? A house represents not only the largest investment most people make, but is also the emotional center of the family. So my advice tends to be very conservative in taking on too much risk when it comes to your house. An ARM can be an excellent product if you know you are going to move before the rate will change on your loan. It can also be a good product for the financially astute borrower who accumulates the savings generated by an ARM, and invests those savings wisely. It is very unwise to use an ARM to buy more house than you could afford with a fixed rate – you are setting yourself up for problems that way when your rate adjusts in the future.
Bottom line: if you can afford the worst case payment – that is, the payment at the maximum rate your loan might go to, then you might consider an ARM and accept the risk of a higher payment in return for the savings you will generate. Otherwise, take the safer route of a fixed rate.
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