Does an “ARM” Have a Leg to Stand On?

Does an “ARM” Have a Leg to Stand On?

For home buyers, and for homeowners who are considering refinancing, trying to decide whether to seek a fixed or an adjustable rate mortgage (ARM) can be a bit puzzling.

The main attraction of ARMs is that they typically start off with a lower interest rate than most fixed-rate mortgages. However, one of the dangers of an ARM is that if interest rates rise, your ARM would also rise (i.e., the rate adjusts). If this should occur, an ARM may cost you more over an extended period of time than a fixed-rate mortgage because the low introductory rate associated with many ARMs may be for a limited period of time. After the introductory rate expires, the rates can increase or decrease according to changes in the underlying rate to which the ARM is pegged (e.g., prime interest rate, 1 year Treasury Bill rate).

To protect the borrower from the possibility of rate adjustments getting out of control, ARMs may carry rate “caps.” A typical rate cap might be a maximum 2 percent increase (or decrease) in the rate annually, up to a maximum 6 percent change over the life of the loan.

In effect, an ARM makes the borrower vulnerable to rising interest rates, while a fixed-rate mortgage makes the lender vulnerable to the risk of rising rates. However, many ARMs do provide the option for converting to a fixed-rate mortgage at any time, without closing costs (but with a non-tax-deductible conversion fee).

The Bottom Line

If you are planning to apply for, or refinance, a mortgage consider the following important factors:

1. Compare interest rates both long-and short-term.

2. Determine the affordability. It may be more difficult to qualify for a fixed-rate mortgage than for an ARM.

3. After comparing the rates and affordability requirements of both mortgages, if you feel an ARM is best for you, be sure to include the option to convert to a fixed-rate mortgage at a future time.

ARMs have the potential to save you money, but they come with a twist–if rates rise steeply, you could wind up paying more than you would have with a fixed-rate mortgage. In determining whether an ARM has a leg to stand on, make sure you weigh the advantages and disadvantages of all your options.