Is a Variable Rate Mortgage For You?
After the national real estate market crash and subsequent adjustments, many people are scared of variable home mortgages. This type of mortgage is also known as an ‘ARM,’ which is an acronym for adjustable rate mortgage.
In the past, people would ignore the risk associated with these loans based on the ease of qualification and perks associated with a variable home mortgage. There are pros and cons, and instead of getting scared off by the thought of an adjustable interest rate, see how these loans have changed post-recession.
It’s definitely a buyer’s market out there when it comes to real estate, and while you’re taking a look at what’s out there, see how the loan options have changed. People thought that adjustable rate mortgages would be gone, but instead, what’s happening is the loan vehicles have just been modified.
The Major Benefit of an Adjustable Mortgage – Lower Than Market Level Interest Rates to Start
The one major advantage of putting yourself in an ARM loan – you are given a certain period of time where you are going to have the lower interest rate, no matter what. If you plan on or have the ability to be making mortgage payments over and above the low payment on the initial adjustable rate, more of your money goes to paying down the actual principle loan amount.
With fixed rate mortgages, the interest portion is front loaded, so when you make your mortgage payment, the largest part of that payment goes to the bank in the form of the interest payment, and a much smaller portion goes toward the actual principle of the loan. (Banks want to get their profits faster, of course.)
If you calculate what you actually pay over time on your mortgage, you will find that you pay roughly three times the amount of interest that you do principle on your loan! But, if you are paying a variable rate mortgage and you can pay MORE towards the payment during the low interest rate payment period, you will pay LESS in interest and MORE in principle over the life of your loan, thereby paying less overall for your home.
If you’re not going to make substantial mortgage payments each month, then you’re still getting to enjoy the lower interest rate for awhile. However, the one thing that is the largest advantage in the beginning can turn to a major disadvantage – quickly.
The Major Drawback – Your Interest Rate Can Rise Rapidly
There is always a set period of low interest rates in the beginning of an ARM loan – usually 3, 5, 7 or 10 years, depending on the loan you get. After that period, the rate will usually shift to whatever market rates are at the time.
If you look up the real estate crashes in the late ’80’s/early ’90s, one of the things that contributed to the crashes were the effects of homeowners getting stuck in a home they couldn’t afford once their adjustable rate mortgages shifted to fixed rates. In some cases, a person’s mortgage doubled or even tripled overnight.
The challenge is that ARMs usually adjust to whatever the market rate is at the time your adjustable period ends, so whatever that rate is, that is the rate your are going to get whether you can afford it or not.
If you bought a home on a variable rate mortgage with a low interest rate – and you can barely afford the payment – you are probably going to be in trouble when the honeymoon phase ends and the rates go up. With no control of what mortgage rates will be in the future, ARMs can be very risky if you don’t know what you are doing or you aren’t in total control of your level of income.
Some People Start with an ARM and Then Refinance Into a Fixed Rate Loan
We talked in an earlier article about the benefits of a fixed rate loan. In today’s market of historic low interest rate levels, if you can qualify for a fixed rate loan, it is almost a no-brainer.
You could start off with an ARM and an even lower interest rate then currently available, but you would have to keep an eye on interest rates and make sure there was no prepayment penalty on your ARM loan. This way, if signs showed interest rates were going up, you could start the process of refinancing into a fixed-rate loan.
This way you would get the benefits of both the lower than market level interest rates to start and the peace of mind of fixed rates in the future.
Only You Know If Variable Rate Mortgages are Right for You
So is the adjustable rate mortgage right for everyone? The obvious answer is no, and that is why you must look at the specifics, weigh the pros and cons and then make an educated and financially sound decision for yourself regarding the purchase of your new home.
The introductory interest rate is definitely enticing, and you do need to understand the full importance of why the lower initial interest rate is ideal. That interest early on really hinders you from paying down your principal balance, so the lower interest rate with variable home mortgages really could give you a boost.
One thing you do need to keep in mind is that markets changes, economies and economic policies change and you cannot control those things. Use common sense, math and remove your emotions as much as possible. Whatever you do, DO NOT go for an ARM with the attitude that, “Well, I can afford the payment now and I will worry about the payment when it shifts to a fixed rate loan later.”
That is a financial disaster waiting to happen. Make sure you are reasonably sure you can afford not only the low payment now, but the possible payments in the future. A good mortgage broker can help walk you through how to make these estimations.