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Adjustable Rate Mortgages Are Not Evil

Adjustable Rate Mortgage

Adjustable Rate Mortgages, known as ARMs, got a bad rap during the recent crisis, but the ARMs offered these days are different from the ones offered then. For the right type of borrower, even a first-time home buyer, these adjustable rate mortgages can be great products that save you lots of money on your mortgage.

As the name indicates, ARMs have adjustable mortgage rates that fluctuate according to general economic conditions, as opposed to fixed-rate mortgages, which offer the same interest rate for the life of the loan. Before you start gasping for air at the thought that the interest rate on your mortgage might increase, you must know that hybrid adjustable rate mortgages available in the market today have an initial fixed rate period of either 3, 5, 7, or even 10 years.

During this initial fixed rate period, the mortgage rate stays the same. If you locked in a 3.75% interest rate, it’s going to stay at 3.75%. It only starts to fluctuate after the initial fixed rate period expires. The benefit to you is that the interest rate during the initial fixed rate period is lower than the interest rate of most fixed rate mortgages and can lead to significant monthly savings.

So what’s the risk of an adjustable rate mortgage? Well, that you might stay in your property longer than the initial fixed rate period and that the interest rate may increase after the initial period expires, leading to payment shock.

But even if this happens, these products have interest rate adjustment caps that limit the amount by which the interest rate can increase after the initial fixed rate period expires.

Let me explain this a bit more:

Adjustable rate mortgages have three interest rate adjustments caps to protect the borrower from sharp rate spikes. These are:

  1. Initial rate cap: applies to the first interest rate adjustment after the initial fixed rate period expires.
  2. Periodic rate cap: applies to all subsequent rate adjustments after the initial adjustment.
  3. Lifetime cap: applies to all adjustments so that the interest rate on your loan can never be higher than the lifetime cap.

To illustrate how these caps work to protect the borrower, let’s take a typical adjustable rate mortgage with an initial fixed rate period of 5 years, an initial interest rate of 3.75% that adjusts once per year after the first 5 years, and interest rate caps of 2/2/5 (initial rate cap of 2%, periodic rate cap of 2%, and lifetime cap of 5%). What this means is that the interest rate cannot increase by more than 2 percentage points at the initial adjustment (no higher than 5.75%) nor can it increase by more than another 2 percentage points at any adjustment after that. Over the life of the loan, the interest rate can never go above 8.75% (i.e., 3.75% plus 5%).

However, even with these caps, if your mortgage rate increases, you might experience payment shock and be unable to make your monthly mortgage payment. This is precisely why these products are not for every type of borrower.

So when is an adjustable rate mortgage a good choice for you?

This is a very case-specific decision, but let’s start with a good rule of thumb. An adjustable rate mortgage could be a good choice for you if you meet the following five criteria:

  1. You have cash available to make a higher down payment – since adjustable rate mortgages typically require at least 10% down (versus the 5% down required for most conventional home loans).
  2. You are keeping the property for a short period of time – less than 7 years.
  3. You have a good level of certainty that you won’t be staying in the property longer than you expect.
  4. You can financially tolerate a measured mortgage payment increase.
  5. You will be able to sleep at night knowing that your interest rate and your monthly payment might increase.

Of course, a rule of thumb is a good starting point, but it shouldn’t be your ending point too. Taking out a mortgage is serious business and you should treat it as such. Take the time to really assess your situation, determine how much home you can afford, and find the right loan to fit your needs.

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