Is adjustable rate mortgage a favorable choice:Why and When?

Sam · Last edited by Sam on Tue Sep 11, 2007 2:53 am

Adjustable rate mortgage (ARM) is a home loan on which the interest rate and monthly payments keep changing at regular intervals with changes in the economic index linked to it. It's an attractive option for potential home buyers as well as borrowers willing to pay down their long term mortgages under certain circumstances.

Initially available at a low interest rate, the ARMs carry with them the risk of rising interest rates and payments. As such, homeowners availing such loan programs need to keep up their income in accordance with the probable changes in rates and payments.

Why should you choose an ARM?
This type of loan program requires you to carry on with varying monthly payments at certain intervals of time. Since there can be significant changes in the payment, such loan programs are considered to be risky compared to fixed rate mortgages on which you can maintain stable monthly payments. In spite of this drawback, you can benefit from this loan product depending upon your financial needs and circumstances.

Some of the reasons for which the adjustable rate mortgages are widely popular are given below:

Boost up your savings through low rate

With an adjustable rate loan, you can avail a low initial interest rate (even lower than the rate on a 30 year fixed rate mortgage) which remains fixed for a certain period of time. This helps you to keep aside a certain amount of cash each month on account of lower monthly payments.

Let's take an example:
We shall consider a 1 year adjustable rate mortgage having a loan term of 30 years during which the interest rate changes on a yearly basis. The loan is offered at an interest rate of 5.6% with zero points. Also, we shall assume a 30 year fixed rate mortgage at 7.5% with zero points.

Now, on a loan amount of $250,000, the 1 year ARM will yield a monthly payment of $1435.20 whereas the 30 year fixed mortgage will require a monthly payment of $1748.04 – a difference of $312.84 for a month and around $6864 for a year. You can use this extra money to pay off other debts, carry out your expenses or repair any portion of your home. Or else, you can even invest the extra amount. And, while you do so, be careful that you don't overspend and incur into additional debts.
Qualify for a higher loan amount

Lenders may consider your income in order to find out if you can afford the first year payments on an ARM which are based on low interest rates. Based on certain calculations involving your income and probable payments, the lender can allow you to qualify for a larger loan. This is one factor which drives borrowers towards this kind of mortgage product in spite of future risks associated with the loan program.
Plan to move out within a few years

With an adjustable rate loan, you can plan to shift in a few years time. For instance, you have taken a 5 year loan which offers you a low initial rate that will change only after the first 5 years. Now, if you need to relocate in 3 years, then at the end of the third year, you can sell off the property and pay down the debt from the sale proceeds. But make sure that there isn't a prepayment penalty and even if it exists, you can afford to pay it.
Payments can go down

It's true that the monthly payments on your loan will go up when interest rates rise. But the opposite is also true – payments can reduce if the market changes and interest rates go down. So, adjustable rate loans may be risky as rates can rise up to any extent resulting in higher payments but rates can also go down.

When is it suitable to choose an ARM?
It's best to go for an adjustable rate loan when you meet any of the circumstances given below:

You wish to get a loan at low initial rate.
You want to make your savings bigger through low initial payments, such that you can invest the savings for a better return.
Wish to occupy the property for a short term of 3 to 5 years and then shift to a different location.
You feel that you can carry on with frequent payment rises as the interest rates go up.

Before you choose an adjustable rate mortgage, ask yourself a few questions which can help you to take the right decision. Here's a sample of such questions.

How long do I plan to stay in the property which will secure the loan?
With my income, can I afford to make higher payments if interest rates go up?
Will the monthly payments go up even when interest rates do not increase?
Do I intend to borrow a large sum of money in future?

If you're shopping for a home loan and a fixed rate loan isn't that appealing or it does not fit your budget, you can think about going for adjustable rate loans. What's important is to assess your financial needs, evaluate your financial strength and then decide whether an adjustable rate loan can best serve your purpose.

Related Readings:

Related Forum Discussion:

Caron

Adjustable rate mortgage (ARM) are preferred by borrowers as these often start off with low interest rates and hence provide the opportunity of low monthly payments. But before accepting such a deal, you should consider as to whether it is a favorable option. The best way to determine this is to know which is the rate index used for the ARM.

The ARM index represents a calculation of the general interest rates applied on a various financial products and based on this, the actual rate on your ARM is set. The ARMs start off with an initial low rate which after a certain period keeps changing at regular intervals due to a change in the index.

The financial products associated with arm index are:

COSI Index:
It is the weighted average of interest rates that financial institutions under the Golden West Financial Corporation charge on checking accounts, savings accounts and certificate of deposit accounts. The index does not vary as often as other ARM related indexes.
Certificate Deposits (CDs):
It refers to an index determined on the basis of interest rates on six-month Certificate of Deposits.
Treasury Bills (T-Bills):
The Treasury bills are bonds issued by the US Federal Government with maturities of 1, 3 or 6 months. The main purpose of issuing them is to pay off the national debt and other expenses. The interest rate charged on the Treasury Bill is used by lenders to calculate the rate to be charged on your ARM.
Cost of Funds Index:
The Cost of Funds Index is the weighted-average cost of savings, borrowing or advances of the 11th district members of the Federal Home Loan bank of San Francisco.
Cost of Deposit Index:
The Cost of Deposit Index (CODI) is a stable World Savings proprietary adjustable rate index. It is based on the 12 month average of the 3 month Certificate of Deposit (CD) yields as stated by the Federal Reserve Board. The index is regarded as one of the stable adjustable indices in the mortgage industry.
Libor Index:
The Libor index represents the interest rate that is charged by international banks while borrowing US dollars on the London currency markets. The Libor rates vary quickly and can make the ARM interest rate highly unstable.

Indexes are important in the sense that they set the base rate charged on your ARM. But the index rate is just the starting rate to which the margin is added to get the actual rate on your ARM. The margin is constant throughout the loan term. This implies that your ARM rate changes only when there is a change in the related index.

blue · Posted: Tue Feb 14, 2006 5:25 pm Post subject:

Adjustable rate mortgage is gaining popularity faster in the US and 40% of the new homebuyers are choosing it.

But you should be aware of some points while going for it. With the interest rates on the rise, there may be problems for the homebuyers as they may have to make high increased mortgage payments even when the values of their home decrease.

So, while deciding on an ARM, one should particularly judge whether it is going to be a favorable option for him or not.

Regards,
Blue

Guest 0.10 Dollars($)

About a year ago, we bought our home with the help of an ARM at 2.95 percent interest. We knew it would adjust after six months to 5.95 percent interest. That was quite a jump in our monthly payment, but we handled it. However, when we received the lender's IRS 1098 Form, we learned our mortgage balance has grown by about $8,900. When I called the lender, I was told the increase was "unpaid interest." What's that?

Caron · Posted: Sun Apr 16, 2006 9:34 pm Post subject: RE:

Hi,

Welcome to MortgageFit Forums.

Probably the lender should have explained you that 2.95% and your current interest rate, that is, 5.95% don't cover the actual interest rate. The unpaid interest you didn't have to pay was added to your mortgage principle balance each month. This is called negative amortization.

Here your mortgage balance is increasing very month instead of a reduction which usually happens in an amortized mortgage.

Negative amortization helps to keep your monthly payment low.

Thanks,

Caron.

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