Why consider an adjustable-rate mortgage?

Posted by  on Mar 26, 2013
 

Q: In shopping for a mortgage, I keep seeing rates for adjustable-rate mortgages quoted. With mortgage rates so low, why would anybody want an adjustable-rate mortgage? Does anyone really believe rates could go much lower?

A: Agreed that there is more room for interest rates to rise than to fall, but there are at least two scenarios in which an adjustable-rate mortgage (ARM) could make sense for a borrower:

  1. If you plan to move within a few years.
  2. If you are fairly certain of being able to pay off your mortgage within a few years.

What these two situations have in common is that in each case you would only be keeping the mortgage for a few years. This would reduce the risk of rising interest rates, while allowing you to take maximum advantage of the lower initial rate on ARMs. Currently, ARM rates are about 1 percent lower than 30-year fixed rates. If you expect to pay off the mortgage before the initial rate-adjustment period, you can use an ARM to capture the lower rate.

There are risks to this strategy, however. If you don't pay off the mortgage within the initial period, then you will be exposed to interest rate changes. You can use a mortgage calculator to test different scenarios of how much interest rates would have to rise before capturing that lower rate initially would be no longer worthwhile. Also, an amortization calculator will tell you how much equity you will have built up before your planned repayment date - this would be especially important in the scenario where you were planning on moving in a few years. In just a few years, you will have little chance to build up equity to protect against price fluctuations.

Finally, it is important to understand all the terms of an ARM; but for either of the above scenarios, it is especially important to know if there is a prepayment penalty on the loan.



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