Adjustable Rate Mortgages - Advice for Borrowers

What is the adjustable rate mortgage and how does it work? When should a first-time home buyer consider using an adjustable rate mortgage, and when should it be avoided? These are the questions I would like to address in today’s lesson.

A Definition to Start With

But first, let’s start things off with a basic definition of the adjustable rate mortgage. Also referred to as an ARM loan, the adjustable rate mortgage is exactly what it sounds like — it’s a home loan where the rate adjusts over the term of the loan. This is obviously very different from a fixed-rate mortgage where the interest rate remains the same over the life of the loan.

ARM loans have been in the news a lot lately, mainly because they are tied to the foreclosure crisis we’ve seen in this country. This leads a lot of people to believe that adjustable rate mortgages are evil in some way. But this is simply not the case. In fact, it’s possible to use an adjustable mortgage wisely and save money, if you know what you’re doing. But therein lies the rub — you have to know what you’re doing. And that’s the purpose of today’s article.

One of the most common types of adjustable rate mortgages is the 5/1 ARM loan. The first number represents the length of time in which the interest rate will remain fixed. The second number represents the frequency with which the interest rate will adjust, after the fixed phase. So for a 5/1 adjustable rate mortgage, the rate will remain fixed for five years, and then it will adjust every year after that for the life of the loan.

When to Use an Adjustable Rate Mortgage

Let’s talk about the different scenarios where it might make sense to use an adjustable-rate mortgage. The only time I would recommend using one of these loans is when you know you’re only going to be in the house for a few years. For example, somebody who is in the military, or somebody with a job transfer where they’ll only be in an area for five years or so, might be able to use the adjustable rate mortgage to save money.

In most cases, an ARM loan will have a lower interest rate during that initial fixed phase than a traditional fixed-rate mortgage. So if you buy a house with an adjustable loan and a lower interest rate, and you sell the house within a few years before that rate adjusts, you could save money while avoiding the risk of a interest rate hike.

Refinancing the Arm Loan

Right now, we are seeing a lot of homeowners trying to refinance their adjustable-rate mortgages — mainly to avoid the risk of paying more interest. In most cases, when an ARM loan resets to a different interest rate, it will be a higher rate and therefore will increase the size of the homeowner’s mortgage payment. This is the kind of risk you take when you use an adjustable loan.

Granted, there are those times when the adjustable rate mortgage resets to a lower rate. This is what we are seeing right now, in the wake of government stimulus plans that have driven rates way down. But these times are the exception to the rule. So if you use an adjustable mortgage, you need to realize there’s a very good chance your interest rate will go up when the loan resets, which means your monthly payments will also increase.

The Adjustable Risk Game

Some people roll the dice by using an adjustable rate mortgage when they know they’re going to have to refinance before the adjustment period. Sometimes this works out, and other times it does not.

Take, for example, the recent decline in home prices across the United States. A lot of home buyers chose adjustable-rate mortgages in order to save money during the first few years, and they planned to refinance the loan after that introductory period to secure a fixed rate. But the problem for many homeowners is that their home value has dropped to the point that they owe more on the mortgage than their home is currently worth. In other words, they are upside down in the mortgage loan. In this kind of scenario, it’s very difficult to refinance an adjustable mortgage. Most lenders will require you to have positive equity — usually up to 20% — in order to qualify for refinancing.

Like I said, there are quite a few risks involved with the adjustable rate mortgage loan. But if you know what you’re doing, you can use this type of loan smartly and safely, while saving money in the process. The key is to understand how these loans work and to make sure you know what you’re getting yourself into. It also helps to have a good idea of where you’re going to be living five or seven years from now. In other words, you need to have a plan for when your adjustable rate mortgage loan resets to a different rate.

I hope this article helps you understand how the ARM loan works, when it’s a good idea to use one, and when it’s best to avoid them. Good luck.

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