Adjustable Rate Mortgages Pros and Cons

If you are shopping for a mortgage, you may already know that there are a variety of different types of home loans to choose from. One popular type of home loan is an adjustable rate mortgage, also known as an ARM.

Adjustable rate mortgages are popular because the starting interest rates and payments tend to be lower than fixed rate mortgages. However, an ARM requires that the buyer share in some of the risk associated with the interest rate, which means that those great rates and low payments may not last for long.

Basically, instead of having a guaranteed interest rate for the life of the loan, as a fixed-rate mortgage does, an ARM’s interest rate “floats”. Most adjustable rate mortgages have an initial period where the interest rate won’t go up, but it’s hard to predict what it will do after that period. The interest rate is calculated by adding an index -- basically a representation of what mortgage rates are doing currently -- and a margin -- a percentage that is predetermined and laid out in your loan paperwork. Many adjustable rate mortgages also have caps, to prevent the rates or payments from going up too much.

Pros of an Adjustable Rate Mortgage

Although many people view an adjustable rate mortgage as something of a gamble, there are some definite advantages to be had.

• Your initial interest rate and payments may be lower than a fixed-rate mortgage would give you, making it easier for you to qualify for the loan.

• You’ll have an easier time meeting your payments during the first couple of years of owning your home.

• If mortgage rates drop dramatically after you buy your home, you won’t be stuck at a higher rate for the life of your loan.

• If you don’t plan to own your home for more than a few years, an ARM might give you lower payments and a lower rate for that period of time.

Cons of an Adjustable Rate Mortgage

The pros of an ARM are worth the risks to some people, but make sure that you consider the cons carefully before making your decision.

• Your rates can rise dramatically, meaning that you pay more over the life of the loan than you would on another type of loan.

• Without a good cap, your payments might rise to more than you can afford, possibly causing you to suffer credit damage or lose your home.

• If you plan to stay in your home for a long period of time, an ARM may cause you to pay more over time than you would with another type of loan, despite the low starting rate and payments.

You can protect yourself from some of the cons by knowing what you’re getting into before you make your decision. Research the index that your ARM will be dependent on, and see if it tends to be high, low, or average when compared to other indices. You should also discuss the caps on the ARM with your mortgage broker, and make sure that the caps will protect you from getting stuck with a payment much higher than what you can afford.

An adjustable rate mortgage is clearly not a good choice for everyone. People who may like the benefits of an ARM include people who expect their income to rise considerably over the next couple of years, or people who expect to resell or refinance their home in the next few years.

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