Adjustable Rate Mortgage - Salvation Or Financial Trap

Posted by Nick Niesen on October 29th, 2010

If you are currently trying to buy a new home you've probably noticed the endless stream of numbers being tossed to and fro. Things like monthly payment, down payment, home price, affordability and a host of other fees and figures. This can be daunting but in a strange way all these requirements, in the form of numbers can be used to work for you.

It's not easy to see but there is a wide mix of funding options available to home buyers today. Brokers, banks and other lending institutions have an amazing variety of mortgage options from traditional 30 year fixed to the less conventional but ever more popular 2 year adjustable rate mortgages.

How do you decide what option is best. Of course, that depends on your current circumstances. A few key factors will include your credit score, how long you plan on staying in your home and whether you have money for a down payment.

The traditional 30 year fixed rate mortgage will give you the peace of mind of knowing that the interest rate of your mortgage is not at the whim of the ever changing housing market. On the other hand, if interest rates drop it will cost you thousands in refinance charges to refinance your mortgage to a lower rate and if your financial or credit situation has changed you may no longer qualify at the best rates.

An alternative to the traditional 30 year fixed mortgage is the adjustable or variable rate mortgage - also known as an ARM. An ARM is different than a fixed mortgage because the interest rate is normally dependant upon some type of index (i.e. the 10 year Treasury Bill). ARMs come with an initial lower interest rate and monthly payment - that's their appeal, but with the lower initial rate comes additional risk because the interest rate is based on index rates that are subject to change.

On the other hand, you also have the potential to benefit if interest rates fall but rates normally have to fall quite a bit for you to realize any savings due to a number of reasons beyond the scope of this article. Just be aware that the odds of your rate dropping, is very low regardless of what interest rates do.

There are advantages to obtaining an adjustable rate home mortgage other than the initial lower monthly payments. Factors include: if you intend to pay down a big portion of your mortgage principal early or if you anticipate higher income in the future or if you would like to completely payoff your mortgage as quickly as possible. The initial lower interest rate of an adjustable rate mortgage allows you to apply more of your monthly payment to the principal.

You should understand the risks associated with an adjustable rate mortgage before agreeing to one so be sure to ask your lender to explain the interest rate ceilings or caps associated with the loan so that you are not blindsided a few years down the road with a much higher mortgage payment because your interest rate just jumped 2 points.

A viable option if you have little income flexibility is to ask your lender about payment caps. Payment caps can help to stabilize your monthly payments during periods of interest rate fluctuations. However, on the down side, this option can result in negative amortization on your loan. Negative amortization occurs when the balance of your mortgage increases because your mortgage payments are not big enough to cover both interest and a portion of the outstanding principal.

Clearly there are both pros and cons of adjustable rate mortgages but one option you may want to seriously consider is an option that allow you to convert your mortgage to a fixed rate if interest rates go against you. In most instances, this option will cost you some money but the fee is much less than a full refinance and could potential save you thousands of dollars and bunch of stress.

For options in finding the best mortgage, new or refinance, check out the links below.