Advantages and Disadvantages of adjustable rate mortgages

Advantages

With adjustable-rate mortgages, your mortgage interest rate goes up and down. If rates are high and likely to fall, this is an advantage. If rates are low and likely to rise, this is a disadvantage. adjustable-rate mortgages have some other attractive attributes, but interest-rate forecasts should be the major factor in deciding whether or not to get an adjustable-rate mortgage.

If you think rates are going down, consider an adjustable-rate mortgage. If you think rates are going up, get a fixed-rate mortgage. If interest rates stabilize or fall, an adjustable-rate mortgage will be less expensive than fixed-rate mortgages over the long term.

The initial interest rate of adjustable-rate mortgages is typically 2 percent to 3 percent lower than traditional fixed-rate mortgages. adjustable-rate mortgages are generally more affordable in the first two years, and you do not need so much income to qualify for an adjustable-rate mortgage as for a traditional fixed-rate loan.

Most adjustable-rate mortgages are assumable. This could make it easier to sell your home if interest rates increase to the high levels prevalent during the early 1980s.

Disadvantages

With an adjustable-rate mortgage, your mortgage interest rate and monthly payment can and probably will go up sometime during the life of your loan. In the hypothetical example, the adjustable-rate mortgage's initial 5 percent rate in year 1 rose to 10 percent in year 6. That kind of increase in rate would cause a 65 percent increase in your monthly payment even with all of the protective caps. Few household budgets can absorb that kind of mortgage payment increase without feeling a pinch.

In 1993, the One-Year Treasury Security Index (the most common adjustable-rate mortgage index) ranged from 3.25 percent to 3.60 percent. Over the ten years from 1981 to 1990, it has ranged from a low of 5.5 percent to a high of 17.2 percent. Overall interest-rate levels may go lower than they are today, but based on the past ten years, rates have a lot more room to go up than down. Predicting interest rates is difficult for even the most skilled economists. It is even more difficult if you are betting your mortgage payment on your predictions.

Important! Before you decide to get an adjustable-rate mortgage, be sure to get answers to the following three questions:

1. If interest rates (and the adjustable-rate mortgage's Index) stay at the same level as today, what will my monthly payment be after one year? Two years? Three years?

2. If interest rates (and the adjustable-rate mortgage's Index) rise precipitously, what will be the maximum monthly payment that I might possibly have to pay? Can I afford it?

3. Will there be negative amortization that increases my loan?

You need to answer question 1 because those are the payments you will most likely be making. Usually, these payments will be disclosed on your preliminary and final Truth-in-Lending disclosures provided to you by your lender.

You need to know the answer to question 2 because this is the worst-case scenario. If you keep your home for 30 years, rates will rise dramatically at least once or twice during that period. To calculate the maximum payment in a worst-case scenario, calculate the maximum interest rate (initial interest rate + life interest rate cap) and multiply your loan amount by the mortgage payment factor for the maximum rate to determine the maximum payment.

You should feel comfortable that you can afford the expected payment increases as well as the worst-case payment increases.