Question

You are about to purchase your first home and receive an advertisement regarding adjustable-rate mortgages (ARMs). The interest rate on the ARM is lower than that on a fixed rate mortgage. The advertisement mentions that there would be a payment cap on your monthly payments and you would have the option to convert to a fixed-rate mortgage. You are tempted. Interest rates are currently low by historical standards and you are anxious to buy a house and stay in it for the long term. Why might an ARM not be the right mortgage for you?

Answer 1

Adjustable rate mortgage - the type of loan on which the interest rate charges varies. The interest rate charged vary because it based on an external benchmark or index, say 10 year government bond. They might even charge an additional margin called ARM margin. Then total interest rate would be

Interest rate = benchmark rate + ARM margin.

Fixed rate mortgage - the type of mortgage in which interest rate remain fixed during the tenure of the loan.

We have to keep in mind that ARM rate changes over the tenure of the loan. Also remember that during early stages ARM rate remain below the fixed rate mortgage rates and then rises as times goes on. When we talk about mortgage loans its for longer time periods. So in long term perspective, the chances that ARM will surpass fixed rate counter part is high. Interest rate being historically low level doesnt mean that the situation is here to stay. In the long term economy can go any direction prompting the interest rates to change accordingly.

ARM loans are cheap during the early tenures. But the down side is that it can increase dramatically during later years. If we are borrowing larger amounts, we could be in more trouble since we have to pay more interest. Preference for ARM loans has dipped since the 2008 financial crisis.

Financial markets are dynamic. So we need to consider several factors before jumping to conclusions. Some of the factors to be considered include

1) size of the loan

2) can we afford to pay the higher interest rates if it rises in future.

3) the direction in which the economy is headed (regarding the movement of the interest rates).

4) how long we intend to use the property.