Understanding Adjustable Rate Mortgages Part I

August 12, 2009 · Posted in News For Homebuyers

Understanding Adjustable Rate Mortgages Part I

In this three-part series, I will discuss what to look for in an adjustable rate mortgage (ARM). I will talk specifically about fixed-to-adjustable rate mortgages such as 3/1 or 5/1 adjustable rate loans.
Many consumers view ARMs as risky or dangerous loans. There is no question that these mortgages come with more coherent risk than a fixed mortgage, but they can often be useful for the right consumer in the right situation. Truly understanding these loans is the first step.
First, let’s cover why people shop for these loans and discuss how they can be beneficial.

Here are some basic questions you should ask yourself before looking for an ARM:
1.) Do I know how long I will keep this loan or property?
2.) Will I be able to budget for a fluctuating payment once the rate begins to adjust?
3.) Is the risk of an adjusting rate/payment worth the savings of an initial, low interest rate for my goals?

If you answered “Yes” to some or all of these questions, it’s worth exploring an adjustable rate loan to see if it fits your goals.
ARMs have a fixed rate for a period of time, and then the rate is adjusted according to the index a particular loan is based on. When shopping for an ARM, it’s important to first consider the length of the fixed period. ARMs often have fixed periods of 2, 3, 5, 7 or 10 years before they adjust. This initial rate is the first number displayed in the name, while the second number represents how often the rate will adjust after the initial fixed period. For example, if you have a 3/1 ARM, your rate will be fixed for 3 years. After the third year, the rate will adjust once and stay the same for the next year. To minimize risk, pick a term that coincides with how long you plan to keep the loan. If you have a property you plan on selling in the next 3-4 years, you may want to shop for a 5/1 ARM. If you plan on selling your property between 5-6 years, you may want a 7/1 ARM.

I usually recommend clients to take a slightly longer fixed period than their planned timeframe for the loan, just to be prepared for unexpected delays. That said, be prepared to pay a higher rate for a longer period of time. Most ARMs will have a lower rate for shorter fixed periods and a higher rate for longer fixed periods.