Should You Consider an Adjustable Rate Mortgage (ARM)?
The popularity of adjustable rate mortgages (ARMs) rises and falls depending upon the overall direction of interest rates, as well as the spread between fixed rate mortgages and adjustables. There are many reasons why one might opt for an adjustable rate mortgage. In analyzing whether you might be a viable candidate for an adjustable, there are many facets you may want to consider before making a decision:
What is the current interest rate spread between a fixed rate and an adjustable? Fixed mortgage rates are based upon long-term interest rates while most adjustables are based upon short-term rates. For example, a one-year adjustable will typically be priced off current one year T bills. Short-term rates are typically lower than long-term rates, which is why adjustables will have starting rates below fixed rate loans. The difference between the two, the spread, is not always the same. If fixed rates are at 5.0% and a one-year adjustable starts at 2.0%, the benefit is clearly seen. If the adjustable starts at 4.5%, the choice is not so clear.
How long are you going to keep the mortgage? Note that the question here is not how long you live in the house. If you convert the home to rental property sometime in the future, you will still be making payments on the mortgage. Also, you may refinance the mortgage in the future and remain in the property. Factors that might affect your long-term use of the mortgage might be your job stability, mobility and the current interest rate of the mortgage. For example, if you purchase a home and obtain a mortgage during a period of relatively high mortgage rates, a refinance is more likely in the future. The average life of a mortgage in the United States ranges from five to seven years depending upon the economic and interest rate environment.
Which direction do you think mortgage rates will move? If you feel that the present level of rates is high and the movement is likely to be down, you are more likely to benefit from an ARM. Note that an opinion of the future of interest rates is just that — an opinion. Yet, if rates have recently moved up, they are more likely to move lower in the future.
What is the life cap of the adjustable as compared to the present level of fixed rates? The major advantage of fixed rates over adjustables concerns the issue of security. With a fixed rate mortgage one will be secure in having the knowledge of their payment over the life of the loan. With an adjustable, long term security comes in the form of a cap on the mortgage rate. This cap is the maximum rate over the life of the loan. If this maximum is close to the present level of fixed rates, then we can say that the worst case is palatable. If fixed rates are presently 6.0% and the life cap of an adjustable is 7.0%, the risk is minimal.
How fast do you expect your income to rise in the future? If you expect your income growth to be strong, it may make sense to opt for an ARM. Your payment will be lower in the short run when your financial plan most needs the assistance.
As you make your decision, it is important to also consider the fact that all adjustables are not alike. Some may have interest and payment changes each year, while others may be fixed for the first ten years of the mortgage. A seven-year ARM provides security and will typically offer a lower rate than fixed rates. The more frequent the changes, the lower the starting rate of the ARM. In addition, most ARMs have caps that limit the amount of change per each adjustment. For example, most one-year adjustables have annual caps ranging from 1.0% to 2.0%.
Another difference between adjustables concerns the index upon which future rate changes are based. Some indices may have a history of being more stable in times of market volatility. In particular, the Monthly Treasury Average (MTA) tends to change more slowly (lagging) than indices directly based upon Treasury Bills or the LIBOR. This would make MTA based adjustables better performers during periods of rising rates, but disadvantageous when rates are falling.
When making your decision concerning a mortgage, be sure to keep an open mind. The right mortgage product today just might become the wrong choice tomorrow. Your economic circumstances may change which would alter your choice. It seems that the external economic environment is forever changing.
Surely, if we could predict the future of interest rates the decision would be easy. Since we can’t make such a prediction, the choice of a mortgage might be best considered one of luck and timing. Yet, with careful planning and knowledge of alternatives we can improve the chances!