If you'd like to go for a low initial rate and payment on your home mortgage with the aim to relocate after a short term, an adjustable rate mortgage (ARM) is what you may choose. Such a loan program helps you to go for a bigger house as because lenders may use the lower payment when qualifying you for the mortgage. In this article, we have tried to explain an adjustable rate mortgage by providing the following topics to watch out for.What is an adjustable rate mortgage?Adjustable rate mortgage is a home loan in which the interest rate and monthly payments are adjusted up or down at regular intervals with changes in the economic index linked to the ARM. Initially available at a low interest rate, these loans carry the risk of rising interest rates and payments. As such, it is suitable for homeowners who go through frequent income hikes.
Why should you go for adjustable rate loan?It's true that going for an ARM is risky because it can increase your monthly payment significantly. Yet, there are certain benefits for which borrowers opt for such a program. Given below are some of the benefits of ARMs:
- 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. While you pay less initially, it helps you save the money and invest it thereby getting higher returns in future.
Let's take an example: We shall consider 1 year ARM 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 consider 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. So, there's a difference of $312.84 per month and around $6864 for a year. This extra money can be used to pay off debts, finance home improvement etc.
- Plan to move out within a few years:
If you plan to shift within a few years, adjustable rate mortgage may be the right option for you. Say for example, you've taken a 5/1 year ARM which offers you a low initial rate that'll adjust 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.
- Qualify for a higher loan amount:
Since lenders qualify you for ARM on the basis of your gross monthly income and gross monthly payment which is quite low in the initial years, therefore chances are that you can easily get qualified. And, you may even get a bigger loan. Thus, you'll be able to afford a larger home.
- Payments can go down as well:
It's true that the monthly payments on your loan will go up when interest rates rise. But the loan payments can get reduced if the market rates go down. Thus, adjustable rate loans may be risky when market rates are up. But there are rate caps and payment caps to limit the increase in rates and monthly payments. However, at times, payment caps lead to negative amortization.
When is it suitable to opt for ARM?It's best to go for an adjustable rate loan in the situations as 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 or maximum 10 years after which you'd like to shift to a different location.
- You feel that you can carry on with frequent payment hikes when rates go up.
What to ask yourself before you choose ARM?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 occupy the property?
- Can I afford to make higher payments once rates adjust?
- Will I be going for auto loans, credit cards, personal loans etc?
- Should I be making extra payments on the ARM?
What to ask lenders when shopping for ARM?When you start shopping for the loan, you should ask lenders the questions as given below: - Can you convert the ARM into a fixed rate mortgage when rates are low enough? Make sure that you know what conversion actually means.
- Under what situations can negative amortization occur with your loan? Will the lender alert you about negative amortization? How does he handle such cases?
- Does the cap apply to the initial rate or the true/standard rate? For instance, if your initial rate is 4.5% and the lifetime cap is 5.5%, then you may think that the rate will go up to maximum 10%. But if the cap is tied to the true rate, then 10% isn't the maximum rate that you may be offered.
- What if you prepay the loan? Is there any penalty involved?
- If you sell the property, will the lender allow the buyer to assume the mortgage? It is important to ask this because assumption isn't possible without the lender's approval.
How do you choose the best ARM loan?Here are 5 tips to help you choose the best loan:
- Check out the true/indexed rate: When you shop for an ARM, don't just go after the low initial rate (Teaser Rate). Instead ask the lender about the true rate or current Indexed Rate, that is, what rate you may currently get after adding the index to the margin. This is because the Teaser Rate is temporary and after the first rate adjustment, rates will go up. Also ask if there is a minimum rate as because some lenders may charge the minimum rate even if index goes below that rate.
- Use margin to compare loans: When it comes to comparing adjustable rate mortgages with the same index, check out the one with the lowest margin. There are lenders who may offer a low initial rate but a comparatively higher margin. This will lead to frequent rate hikes and hence you may be in trouble making payments.
- Find out variations in the index: To make sure that you can manage the changes in the index, you need to ask the lender for a chart that reflects such changes for the past few years. Take a look at a few years of changes in the index. This will help you understand how stable/volatile the index is.
- Check out the adjustment interval: Frequent adjustments bring frequent changes in your payments. As such look for a longer adjustment interval so that your payments don't vary often.
- Look for lifetime cap protection: See that your loan has lifetime cap protection, which prevents the newly adjusted rate from going up beyond a certain limit in spite of market rates getting even higher.
- Find out what's the periodic rate cap: Ask the lender what the periodic rate cap is like. See that the rate doesn't go up too high periodically even though on the whole it may be as high as 10% or more. Ask the lender what may happen in case rates jump more than the periodic rate cap.
What are the Adjustable rate mortgage types?The 3 main types of adjustable rate loans are listed below:
- Hybrid ARMs: These are adjustable rate mortgages which have fixed rates for an initial period of time after which the rates keep changing at regular intervals. For example, the 5/1 year ARM, 3/1 year ARM etc are hybrid loans. Know more ...
- Interest-only ARMs: This kind of a loan requires you to pay only the interest for a specific time period, say between 3-10 years. So, your interest-only payments will be lower during this period. At the end of the interest-only period, your payments will go up even though rates may not increase. This is because you'll have to pay towards the principal amount. However, the longer the interest-only period, the higher can be your monthly payment after the interest-only period is over.
- Pay Option ARMs: This type of loan allows you to choose from a variety of payment options such as minimum payment plan, interest-only payment, and fully amortizing payment plan. However, with the minimum payment plan, chances of negative amortization are higher. Know more ...
If you're shopping for a home loan and a fixed rate loan isn't that appealing or it doesn't fit your budget, you can go 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 Discussions: |
Caron
