How to Compare Adjustable Rate Mortgages

Maybe you know this song—“the loan bone’s connected to the ARM bone, the ARM bone’s connected to the index bone.” Maybe not. An ARM, or adjustable rate mortgage, can be a great opportunity or a costly mistake. If you are confident you will soon be making more money than you do now or want more home than you can qualify for currently for a fixed rate mortgage, an adjustable rate mortgage can help you get into the home you want. If you are planning to move within 7 years, you may also benefit from this loan type. Adjustments are made periodically to ARMs and this is where the high costs can enter in. As early as a year before your adjustment period, you should begin watching the index your interest rate is based upon in addition to other loans available. Consider refinancing before your loan adjusts and you could save lots of money.

Instructions

Difficulty: Easy

1. Contact loan brokers to get a current quote. You'll need to know the following information:
   
   - Term of fixed-rate and frequency of adjustment (i.e., 5/1 is a loan that offers a fixed rate for 5 years and an adjustment every 1 year).
   - Index used to adjust the interest rate. Common indexes are Federal Housing Finance Boards National Average rate and Federal Funds (treasury notes and bills).
   - Adjustment margins. This is the amount, usually a flat percentage rate, that will be added to the index to determine your adjusted interest rate.
   - Rate cap (often referred to as the over/under). This is a range of highest and lowest interest rates your loan can reach.
   - Payment cap. This is the maximum amount your payment may increase at each adjustment period
2. Do a Web search for “adjustable rate mortgage calculator” or “adjustable rate mortgage amortization table” to access an instant, automated calculation of your rates and payments.
3. Compare the range of rates and the high cap. The closer your over/under caps are, the better.
4. Compare monthly payments at each of the potential interest rate adjustments. If you can’t afford it, you must either refinance or sell the home before the adjustment.

Tips & Warnings

• ARMs can end up costing hundreds of thousands of dollars over a traditional fixed mortgage because the rate can go up substantially. ARMs are best for homeowners that anticipate a significant increase in income and eventual refinance or a limited (under 10 years) stay in the house.
• Be wary of initial rates that are very low. These might be teaser rates that only impossibly high credit scorers will receive.
• Beware of banks that offer a promise of favorable market prices when your loan adjusts. If you want your fortune told, look for someone with a crystal ball.
• Never buy more house than you can reasonably afford, no matter how great of a deal your ARM may be. Eventually it will adjust and your payments will go up. A foreclosure in 7 years isn’t worth living in a home you can’t afford now.