The Pros and Cons of Adjustable Rate Mortgage

An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can change periodically based on an index. Common indexes used to determine the interest rates include:

• One-year constant maturity treasury securities (CMT)

• Cost of Funds Index (COFI)

• London Interbank Offered Rate (LIBOR)

• A lending institution's own cost of funds

The ARM structure ensures a steady margin for the lender, as the mortgage payment adjusts—either increasing or decreasing—over time.

Pros of an Adjustable-Rate Mortgage

The initial interest rate on an ARM is typically lower than that of a fixed-rate mortgage, resulting in lower monthly payments. This lower rate may allow borrowers to qualify for a higher loan amount, as lenders may calculate affordability based on these initial payments. ARMs can be especially appealing to those planning to stay in a home for a short period, like three to five years, as they can take advantage of lower interest rates and build more equity in a shorter time.

Cons of an Adjustable-Rate Mortgage

The primary risk with ARMs is the potential for rising interest rates, which would increase monthly payments. Borrowers must consider whether they can handle higher payments in the future, especially if they anticipate income changes. Additionally, some ARMs come with prepayment penalties, meaning borrowers could face financial consequences if they try to pay off the loan early.

Another potential pitfall is the payment cap, which limits how much the mortgage payment can increase but does not cap the interest rate. If interest rates rise significantly, and payments exceed the cap, the excess interest is added to the principal, resulting in negative amortization. This means paying interest on the interest, leading to higher overall costs and potentially resetting the payment cap once a certain threshold is reached.

Ambiguous Factors of Adjustable-Rate Mortgages

Several factors can influence the decision to choose an ARM, which can be seen as either advantages or disadvantages depending on individual circumstances. These include:

• Lifetime Interest Rate Cap: This cap limits how much the interest rate can increase over the life of the loan, providing some protection against drastic rate hikes.

• Periodic Adjustment Caps: These caps limit the rate of increase between adjustment periods, offering more predictable payment changes.

• Margin: The lender adds a margin (a profit percentage) to the index rate, affecting the overall interest rate. Margins vary between lenders, so comparing offers is crucial.

In summary, an ARM can be a beneficial option for certain borrowers, particularly those who plan to move or refinance before rates potentially rise. However, it requires careful consideration of future financial stability and the flexibility to adapt to possible changes in payment obligations.