Flexible mortgages vs. fixed rate mortgages

Adjustable Rate Mortgage

An adjustable rate mortgage is one where the interest rate on the mortgage changes with the changing index. The typical ARM (adjustable rate mortgage) has a fixed rate for a period of time and then the rate will move with the current interest rates. The fixed period rate is usually lower than a conventional mortgage interest rate, but at times can end up higher than a fixed rate mortgage taken out at the same time. There is usually one of two reasons why homeowners take out flexible mortgages. The first of these may be to allow the new homeowner to pay a lower mortgage payment for a few years. After that period of time, the interest rate will be susceptible to market forces and either rise or fall. The second reason may be that the homeowner plans to live in the house for a relatively short time and is trying to keep the mortgage payment as low as possible.

One of the risks of buying a home and using an adjustable rate mortgage is that rising interest rates can make the mortgage payment several hundred dollars higher in a short period of time. When rates are very low, a fixed rate mortgage makes more sense than an ARM. Higher rates may make an ARM attractive, as long as the buyer is well aware of the potential for much higher mortgage payments, if the interest rates rise sharply. The initial savings of a flexible rate mortgage over a fixed rate mortgage has some short-term merit for a buyer who does not plan on staying in the home for an extended period. If rates are stable, then an adjustable mortgages may save the buyer money over time.

An odd situation can develop with an adjustable interest rate mortgage loan. If the flexible rate mortgage you get has a cap on the payment level and the interest rates keep climbing, you could end up with negative amortization. This means that the payment is not enough to cover the interest rate each month and the amount of unpaid interest will be added to the balance. This results in paying payments without reducing the mortgage balance. In fact, the balance could even be growing each month.

Adjustable rate mortgages (ARM's) may allow some borrowers to qualify for a mortgage due to the lower payments. This qualification may not have been possible with a fixed rate mortgage. This can be a significant advantage to a couple whose income is likely to rise faster than the norm. They lock in the home at today’s prices and their rising income will cover future payments with some to spare.

If the interest rates are declining, the adjustable rate mortgage has a positive effect on the payments as the interest rates fall. The payments will slowly decline also over time. This would make a flexible mortgage loan far better than a fixed rate mortgage loan. Most of the time this is not likely to be the scenario, but it could happen. The price of money moves up and down. It would depend on when this loan was put into place.

In order to make a good decision on what type of loan would be best for you, several factors need to be looked at. How long do you intend to be in the home? Which way are the interest rates likely to move, say in the next ten years? How long a fixed period can you get before adjustments are going to be made each year? What would the payment be if it were capped? Could you afford the cap payment? These are some of the areas that should be looked at and compared with a fixed rate loan. An ARM is a means to an end, but it may not be the best choice for your situation. Add up the pluses and minuses and see where you come out in your analysis.