Adjustable Rate MortgageAn adjustable rate mortgage can be a useful tool when fixed rate loan rates begin to rise. In recent years, many lenders have introduced some vary creative programs which can give you an opportunity to actively manage your mortgage payments. Adjustable rate mortgages have a rate that is fixed for a specific period of time and then begin to adjust periodically. When evaluating any adjustable rate mortgage there are several things in addition the rate that you will need to evaluate. 1) Fixed Period An adjustable rate mortgage will always have a period of time where the rate is fixed. These fixed periods can range from 1 month to 10 years, although many lenders have dropped their 10 year offering as their pricing was actually higher than fixed rates. As fixed rates rise, it will be interesting to see if they make a comeback. There are several measures you should consider when looking at the fixed period such as the length of time you plan to remain in the home and your tolerance for potential changes in rate in the future. One good way to think about this is to consider who is assuming that risk. In a 30 year fixed loan, the lender has assumed all of the risk, and you have none so that loan will have the highest rate. At the other end of the scale is the 1 year adjustable rate loan where you have assumed most of the risk and the lender prices the product accordingly. 2) Index The index the loan is written against is one of the most important factors to consider and I am constantly amazed when I talk with a potential client that another lender simply gave them an interest rate without even discussing which index the loan is tied to because the index will have a huge impact on your rate after the fixed period. In years past, an adjustable rate mortgage was usually tied only to the 1 year constant maturity treasury index (the average cost of short term borrowing by the Federal Government). However, today loans are available which are tied to many other indexes such as:
Here is a 10 year average comparison between a 30 year fixed and fully indexed LIBOR, MTA, COFI, and the 1 year Treasury Index. Here is the above data in chart form. 3) Margin The Margin is the number which is added to the index to determine your interest rate after the initial fixed period. The margin can vary widely from index to index and from lender to lender. Consider this, if the rate is the same on 2 five year adjustable rate mortgages but one is indexed against the 10 year treasury which at the time of this writing is at 4.40 and carries a 2.5 margin and the other is indexed against the 1 month LIBOR which is at 1.8 and carries a margin of 2.6, which is the better loan? Clearly it is the LIBOR based product. 4) Caps All adjustable rate mortgages carry rate change caps, frequently described as 2/6. This would restrict the rate change (up or down) to 2% at any rate change point and no more than 6% over the life of the loan. For example, if you had a start rate of 4.5%, in the worst case, your rate at the change could not be more than 6.5% and the loan could never go above 10.5% at any time. Caps can vary from lender to lender and index to index. Many of my clients are converting from fully amortizing payments to an interest only approach with a significantly lower monthly payment. I have some extensive information available. Read more to see if this powerful tool could work for you. * I have included a section on the new Cash Flow Adjustable Rate Mortgage. A LIBOR based product which gives you complete flexibility in managing your mortgage. As an alternative to an adjustable rate mortgage, look at our balloon mortgage section |