Is an Adjustable-Rate Mortgage right for you?
When you shop for a mortgage, whether it’s for a new home or a refinance, you’ll soon hear about adjustable-rate mortgages (ARMs). For some, an adjustable-rate mortgage is an automatic no. If that is the case, it is usually for one of three reasons:
They’re uncomfortable with any risk;
They’re unaware of just how an ARM works;
They can predict the future with relative certainty.
While ARMs definitely have their advantages, make sure you understand them before getting into one.
How ARMs work
All ARMs start out as fixed-rate mortgages for the first 3, 5, 7, or 10 years. An ARM will appear like this, where the first number in the terms “3/1,” “5/1”, or “7/1” denotes the number of years that the rate will be fixed. Usually the lower the number is, the lower the initial rate. During the fixed period, there is no risk and typically a healthy savings. The second number shows how many years before the rates can be adjusted once that fixed period has expired.
After this fixed period, the rate can fluctuate. The rate itself is made up of both fixed- and variable-rate components. The variable component will be based on some index such as Treasury bonds. This is added to the fixed-rate component set by the lender when you determine your starting rate.
Your decision to obtain an ARM should be based on how long you plan to live in this home. Having reasonable expectations for future sale or refinancing is all it can take to make an ARM worth considering. If you believe that you could be living there for a long time, you may want to consider opting for a fixed-rate mortgage. The reason? If you have an ARM and have to refinance at some time in the future when rates are higher, you might find yourself in a fixed-rate mortgage with a much higher rate.
Lenders give you a discounted rate up front because they know the rate will float with the market later on. If you sell your home or refinance again prior to that happening, it’s their loss. You have the advantage here because you control the timing of your next step.
One way to prepare for the possibility of a higher rate and payment later is to pay extra principal each month to reduce your balance faster. If the rate ultimately adjusts up, your balance will be lower and the payment change will be less as a result. As well, you would already be accustomed to paying more.
The Bottom Line
A fixed-rate loan provides the certainty that it will never change. An ARM provides a guaranteed savings but for a limited period of time. The best way to decide is to balance your expectations for using any particular loan with the peace of mind that can come from being assured of stability, even if your timeframe changes.
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