Question:

We are shopping for our first home and it looks like we could cut our mortgage payment quite a bit if we took out an adjustable rate mortgage rather than a 30 year fixed rate loan.  What would you do?

 Answer:

What I would do may not be the best thing for you, because more than the rate is an issue in this decision.  We have used ARM’s extensively over the years and they were very good for us, but there were conditions in which we used fixed rate loans.  First, note that most ARMs now are actually a hybrid of the true ARM and a fixed rate loan.  The interest rate is fixed for the first years; 3/1 means the rate is fixed for the first 3 years.  At the end of that time, the rate may automatically adjust for the remainder of the loan, or you may need to refinance it.  Make sure you know what is going to happen at the end of that initial period.

When we are choosing a loan, we use the following questions to make the decision. 

What is the difference in the payment?  This morning the lowest rates I see in our area are 3.67% for a 30 year fixed and 2.62% for a 5/1 or 3/1 ARM.  Note: these are rates with 0 points – make sure you always compare rates with the same points.  At these rates, your principal and interest payment for a $250,000 loan would be $134 a month lower at the adjustable rate.

 What are all available adjustable rates?  As of this morning, the 3/1 and 5/1 rates are the same…lock in the lowest rate as long as you can.

 How long are you going to live in this house?  Always add a year or two…this may be determined not only by your wants, but also by the market, so give yourself some leeway.  Also, know what happens if you decide to move on and rent the house…you may not be able to adjust the loan at the end of the initial period.

 What happens at the end of the initial period?  Will you have to qualify for a new loan?  If the rate simply adjusts, how is the new rate determined?  Will there be additional loan fees?  What if the value of the home has fallen?  Costs to reset the loan could cut into your payment savings.

 What does the trend line for interest rates look like?  An upward trend line can mean you will be wishing for that earlier fixed rate when the adjustment time rolls around.  If rates are falling, you won’t feel as pressured to refinance (and pay the fees), if your existing rate is already low.

Is there a prepayment penalty?  If you need to change the loan (rates fall further, you want to lock in a long term fixed rate, you are changing jobs and don’t know if you will qualify at the end of the term, you want to keep the home as a rental and know you won’t be able to roll your existing loan when it adjusts) will you have to pay a lump sum for the right to pay off the loan?

As with all real estate questions, there is seldom a simple answer, but hopefully this will give you a guideline for making a decision.  Good luck!

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