Advantages of an Adjustable Rate Mortgage

Adjustable rate mortgages have taken a bad rap in the latest mortgage crisis. Financial pundits from all ends of the spectrum blame the irresponsible use of adjustable rate mortgages and hybrid adjustable rate mortgages for the increasing number of home owners who are delinquent or in foreclosure on their mortgages.

That's unfortunate, since adjustable rate mortgages can offer real benefits to home buyers in many situations. Here's the scoop on the pros of an adjustable rate mortgage.

What an adjustable rate mortgage is

There are many kinds of mortgages, but all of them fit into one of three different types - fixed rate mortgages, adjustable rate mortgages and hybrid mortgages which use features of both adjustable and fixed rate mortgages.
A fixed rate mortgage is one in which the interest rate for the mortgage remains the same for the entire life of the loan, no matter what market interest rates do.

An adjustable rate mortgage is one with an interest rate that can fluctuate up or down. It is usually tied to a specified market index, and has specific rules for when and how much the rate can be adjusted.
The most common hybrid mortgage type features an initial low fixed rate that remains the same for two, three or five years, then adjusts to the market and becomes and adjustable rate mortgage.

Pros of an adjustable rate mortgage

There are a number of advantages to choosing an adjustable rate mortgage. Some of them are advantageous for only one type or buyer or another, others are an advantage for everyone.

1. An adjustable rate mortgage may help you afford a bigger mortgage than a fixed rate mortgage.
Because adjustable rate mortgages often have lower initial interest rates than fixed rate mortgages, they can allow you to qualify for a larger mortgage than a fixed rate mortgage. That means that you can buy a more expensive home because your monthly payments start out smaller. If you're a young home buyer just starting in a career, this can be a major advantage because it allows you to pay smaller monthly payments in the first years when your salary is smaller.

2. The initial payments are lower than they would be with a fixed rate loan because the interest rate is lower.
With a fixed rate loan, lenders accept that if interest rates rise, they will make less money on the mortgage than they would with an adjustable rate mortgage. They offset that 'loss' by charging higher interest rates on fixed rate mortgages than they do on adjustable rate mortgages. That means that you start out with a lower monthly payment. As long as interest rates don't rise, you'll continue to pay lower monthly payments.

3. If the interest rates go down, your interest rate and monthly payments will adjust down automatically.
If you have a fixed rate mortgage and the market interest rates drop significantly, you can only take advantage of that by refinancing your mortgage. Refinancing incurs early repayment fees and other costs that you avoid by having a mortgage that adjusts automatically to the prevailing interest rates.

4. An adjustable rate mortgage can save you a considerable amount if you only intend to stay in your new home for a short time.

Because the interest rate and monthly payments are likely to be considerably lower for an adjustable rate mortgage, If the difference between the rate for a fixed rate mortgage and an adjustable rate mortgage (the spread) is considerable, you could save several thousand dollars a year in those first few years.

In order to figure out if an adjustable rate mortgage is right for you, it's important for you to consider all of the facts about the loan. You should know the following about the mortgage that you're considering:

• How often does the rate adjust? Most adjustable mortgage rates adjust annually, but the adjustment period is up to the individual lender. Some may adjust as often as once a month.


• What is the cap on single adjustments? No matter how much the index used to determine adjustments rises, your mortgage agreement will place a cap on how much the interest rate can increase in a single adjustment.


• What is the annual cap on adjustments? If your mortgage adjusts more often than once a year, what is the most that the lender can raise your interest rates in a single year?


• What is the lifetime cap on adjustments? In addition to the annual cap, your mortgage agreement will also spell out the lifetime cap on adjustments. Can you afford the monthly payment at the cap?


• What adjustment index does the lender use to determine rate increases? A lender can link the adjustment rate to any index that it chooses, and may be allowed to change the index according to the terms of your loan.


• What is the margin? The interest rate that your lender charges will be a certain percentage above the index. This is called a margin. You should know what the margin is so that you can decide if it's fair.