Adjustable Rate Mortgages
If you plan to buy a house or an apartment, you may be inclined to lock in today's interest rates by taking out a long term fixed rate mortgage. Don't be too hasty. A loan with an adjustable rate could turn out to be a better deal.
When you get an adjustable mortgage, the initial rate you pay is usually two or three percentage points lower than on a fixed rate loan. After a year or so the rate rises and then it goes up or down periodically along with interest rates in general.
Adjustable rate mortgages once were limited mainly to less affluent first time homebuyers who could not qualify for the higher priced fixed rate loans and needed that first year break on interest payments. But now so called ARMs are becoming popular among people who are trading up to second and third houses and who can afford whatever loan they want. The reason: If interest rates fall or just hold steady then these borrowers can save thousands of dollars in interest costs compared with what they would have to pay with a conventional mortgage. One study has shown that people who took out adjustable rate mortgages in recent years have done significantly better than those who had fixed rate loans. For example, on a typical 30 year $100,000 mortgage granted in 1981, you would have saved some $38,000 with an ARM by early 1990.
Many homeowners have been paying off their old fixed rate mortgages and trading them for new adjustable rate loans. Generally, it does not make sense to do such refinancing unless the average long term cost of your new mortgage is three or more percentage points below your old one.
It pays to get an ARM if you expect to remain in your house or condo no more than three years before you sell out. The benefit you get from your first year discount should more than make up for any rises in interest rates in the next few years.
You also should take out an ARM if you are willing to shoulder the risk of higher rates later on in return for the immediate use of the cash you will save right now.
In any event, you will have to negotiate with your lender to get the terms you want.
What's the ideal adjustable mortgage? First of all, the interest rate
should be pegged to the one year U.S. Treasury security rate. It tends to rise or fall rapidly. Second, the interest rate and your monthly payments should be adjusted every year, not every several years. Also, the loan agreement would include caps that limit the interest rate changes to no more than two percentage points a year and five to six points over the life of the loan. Third, your initial interest rate should be about two to three percentage points below that of fixed rate loans. Fourth, when you get your mortgage, you should have to pay no more than two points in loan fees a point being equivalent to 1% of your mortgage principal. Fifth, if you are worried that interest rates may soar in the future, you may want to ask your lender for an option to convert your adjustable mortgage to a fixed rate loan in anywhere from two to five years at the then prevailing interest rate. You might also want to ask for a waiver of any penalties for repaying your mortgage ahead of schedule.
Unfortunately, the perfect mortgage does not exist, but you should be able to trade some features for others that are especially important to you. For example, to get a lower interest rate, you can agree to pay additional fees up front. Whatever horse trading you do, however, never accept a cap on your monthly payments. When interest rates rise but your payments don't, the size of your loan grows because the unpaid interest is added to your mortgage.
The Federal Reserve Board and the Home Loan Bank Board have produced a free booklet to help you understand adjustablerate mortgages and read behind the fine print. It is called The Consumer Handbook on Adjustable Rate Mortgages. You can get it from mortgage lenders and real estate agents or by sending 50 cents to Consumer Information Center J, P.O. Box 100, Pueblo, Colorado 81002.
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