The Moving Parts of an ARM
Here's how to weigh an adjustable rate mortgage against a fixed rate mortgage.
You’ve been pre-approved. With your monthly expense chart in hand, decide whether you want a mortgage with a fixed rate, an adjustable rate or a hybrid. A fixed rate mortgage is a no-brainer -- the rate is fixed. But adjustable rate mortgages require more investigation. Ask yourself these questions:
What is Your Initial Adjustment Period?
How long will your low teaser rate last? How long do you have until your interest rate is reset (aka goes up)?
What Will Your Regular Adjustment Period Be?
In other words, how often will your interest rate adjust? Every six months?
What is Your First Adjustment Cap on the Loan?
In other words, what's the maximum amount the interest rate can adjust (read "rise") the first time? Beyond this, what's your Regular Adjustment Cap (the capped amount your interest rate can change at each adjustment) and the Lifetime Cap (the percentage increase your interest is capped for life of the loan)?
What's the Margin?
Lenders make money by adding a margin to their loans. So the interest rate for your ARM will be the interest + the margin. Ask your potential broker/lender how they arrive at their interest rate. They use one of a few different sources, including indexes that can be found in most business newspapers. Lenders typically add a margin of 2.5 percent to 3 percent.
There are many options with ARMs, including some that give you the choice to switch to an FRM within a limited time frame. Some ARMs cap the increase in monthly loan payment but do not cap the interest, which can result in Negative Amortization (aka getting more into debt each month even though you are making your payments). Be very careful when agreeing to ARMs, because they can gobble up your net worth.
What About a Hybrid Mortgage?
If you don’t see yourself staying longer than 10 years in the home you're buying, a hybrid mortgage might a good option. Hybrids start out as an FRM, then become an ARM after a period of time. They have lower interest rates than traditional FRMs and higher rates than standard ARMs.
Keeping the above in mind, choose the length of your loan. These days, loan durations are quite flexible -- with terms ranging from 15 to 40 years.