For first-time homebuyers and homeowners who are considering refinancing their current mortgages, trying to decide between a fixed or an adjustable rate mortgage (ARM) can be a bit puzzling. The future is relatively unpredictable, and it’s nearly impossible to try to guess whether interest rates will rise, stay level, or decrease in the coming years. However, a matter of a few interest rate points can make a big difference in the amount you will pay over the life of your mortgage, depending on the type of mortgage you choose.

Why an ARM?

ARMs typically start off with a lower interest rate than most fixed rate mortgages. However, these low introductory rates may be for a limited period of time only. 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, one-year Treasury Bill rate). If interest rates rise, the ARM would also rise (i.e., the rate adjusts), whereas a fixed rate mortgage would remain the same. If this should occur, an ARM may cost you more over an extended period of time than a fixed rate mortgage.

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. Many ARMs do provide the option to convert to a fixed rate mortgage at any time, without closing costs, but these often have a conversion fee, which is not tax-deductible.

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

The Bottom Line

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

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

2. Determine the affordability of a fixed rate mortgage. 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.

Important Disclosures

Content in this material is for educational and general information only and not intended to provide specific advice or recommendations for any individual.

This article was prepared by Liberty Publishing, Inc.

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