Adjustable Rate Mortgages—

The Good, The Bad and The Ugly

Adjustable Rate Mortgages (referred to as ARMs) are loans with interest rates that change. Most ARMs start with lower monthly payments than Fixed Rate Mortgages because their interest rates are usually lower. But, before you go and jump into an ARM product, there are some serious considerations that you need to think about. Here are just a few:

• Is my current income enough or expected to increase enough to cover higher mortgage payments if interest rates go up?
• What other debt will I need to “take on” over the course of this mortgage, such as a vehicle loan or school tuition bill? Can I afford it all?
• How long do I plan to own this home? (If you plan to sell the home soon than rising interest rates may not pose as much of an issue for you as compared to if you plan to own your home a long time.)
• Can I afford or do I plan to make additional principal payments or pay the mortgage off early?

While there are definite advantages to an Adjustable Rate Mortgage, you must weigh the risk that an increase in interest rates can have on your monthly mortgage payment. While you typically enjoy the lower interest rate and payment at the beginning of the loan, you assume more risk of the rate and payment increasing over the long run.

There are many types of ARMs available and you should certainly do some research before you decided to choose one of these products. The questions that you might want to ask your loan officer would be:

• How long is the adjustment period? This is the time that will be between rate adjustments. Rates can change monthly, quarterly, yearly, every 3 or 5 years typically. For example, if the loan officer tells you that it is 1 year ARM then you need to realize that your interest rate may change every year, therefore changing your payment each year.
• What is the index? The index is the measure of interest rates generally. The most common examples of indexes would be the London Interbank Offered Rate (LIBOR) or the Cost of Funds Index (COFI). A few lenders use their own cost of funds as an index so be sure to ask what index is used.
• What is the margin? The margin is the number of percentage points added to the index rate by the lender. The amount of the margin may vary from lender to lender but is usually constant over the life of the loan. For example, if a lender uses an index of 4% and adds a 3% margin than your rate would be 7%.
• What is the life-time interest rate cap? By law, virtually all ARM products must have a life-time cap on them. This limits the interest rate increase over the life of the loan. Can you afford the mortgage payment at the highest interest rate allowed?
• Is there a payment cap on your loan? This can limit how high your monthly mortgage payment can go over the life of the loan. The concern with a payment cap is that if the interest rates rise but your payment does not increase, this may lead to negative amortization.

What is negative amortization you ask? Negative amortization is when the amount you owe increases even when you are making all of your regularly scheduled payments on time. It occurs when your monthly mortgage payment is not large enough to pay all of the interest that is due on your mortgage. Typically the unpaid interest is added to your principal balance so you end up owing more than you originally borrowed.

While ARMs may sound scary and not the best deal, they truly have advantages for the consumer that understands them and is willing to assume the risk. For example, if a consumer knows that they will only be in the house for a short period of time due to a job relocation, than an ARM provides them with a lower monthly mortgage payment for that time period.

While Adjustable Rate Mortgages have their place in the mortgage lending world, the consumer needs to really understand both the pros and cons of the product to which they are buying into. Don’t be afraid to ask the questions and research the answers to ensure that you are getting the best deal for you. Not every mortgage product is good for every consumer and it is your responsibility to understand the product that you choose.