(Loan Payment Options 2) Adjustable Rate Mortgages (ARM)

Adjustable rate mortgages differ from fixed rate options in that the interest rate typically changes every six months or one year, depending on the program. The interest rate is tied to a popular financial index such as the Treasury bill index or a Cost of Funds Index (COFI). If the index goes up, your payment goes up; if the index goes down, your payment goes down.

Not knowing what your payment is going to be next year can be scary. But, the wise people of the mortgage industry knew that consumers would be wary of such a loan, so they added caps. In mortgage- speak, caps or cap rate means that your interest rate won’t go up more than 1 or 2 percent in any adjustment period or above a 5 to 6 percent ceiling for the life of the loan. The payment is recalculated each adjustment period using the new interest rate and the remaining years of the loan.

So why would you want to go with an adjustable loan? One advantage of ARM loans is that the interest rate starts out 1 to 1.5 percent less than fixed rate. If your adjustment is yearly, that means you get one year of lower rates before the bank recalculates your payment. When you add in a 1 percent cap, you’ve got a deal for the first year. If it takes another year to get up to par, you’ve gotten a good deal for two years. After that your payment depends on the financial index your loan is tied to.
Because of lower initial payments, you can sometimes qualify for a better home. If your income is going up or you’ll only be in the home for two to three years, then ARMs can be a good way to go. Some lenders even offer hybrid loans that start out at an adjustable rate and then convert to a fixed rate down the road, in usually five years or less. Hybrids can be a good way to go by giving you the best of both options. These programs are more complicated, so it’s important to look at the APR and cap terms carefully.
Many buyers who don’t feel comfortable with adjustable rate loans use them to get into a home and then refinance to a fixed interest rate as soon as possible. If values go up and interest rates drop, refinancing to get rid of PMI and the adjustable payment can be a double plus. The bottom line on adjustable loans is to think short term. If interest rates are high, you’ll get an interest break for a year or two while you hope for better times. If your qualifying ratios are tight, an ARM may help put you over the top in getting your dream home.