An adjustable rate mortgage, commonly referred to as an ARM, is a mortgage where the interest rate on the mortgage changes periodically, on a schedule, according to an index. The most common indexes used to determine the interest rates are:
The mortgage payment that you pay will thusly change, either up or down, to ensure a steady margin for the lending institution.
For many people who are looking at mortgages, the adjustable rate mortgage can seem like a great idea, however there are many pros and cons to an adjustable rate mortgage – items that need to be weighed over the short and long term to decide whether an adjustable rate mortgage is right for you or not.
The Pros of an Adjustable Rate Mortgage
The initial interest rate on an adjustable rate mortgage looks great on paper. Most often, the adjustable rate mortgage inserts rate is much lower than a fixed rate mortgage, which also means that the payment is lower. As a borrower, this lower interest rate can also mean that they can qualify for a higher loan amount if the lender is willing to base their ability to pay on the initial monthly payment amount. It’s important to do some research on the interest rates and see where they are sitting at in comparison to the six months to a year prior.
An adjustable rate mortgage is a good idea for investors holding a property for just a few years – from three to five years. Taking advantage of the lower interest rate that accompanies an adjustable rate mortgage is a good idea in this case. It means that you will pay less for the property that you will be renting than if you had a fixed-rate mortgage.
The Cons of an Adjustable Rate Mortgage
The biggest issue with an adjustable rate mortgage is that the interest rate may rise and thusly, so will your monthly mortgage payments. You have to decide whether the gamble is worth it or not. If rents are rising in your market, then you may be able to handle an increase in your mortgage payments.
Some of the adjustable rate mortgages that are offered by lending institutions have a prepayment penalty, which you incur if you pay the mortgage off early. By having this prepayment penalty, you could be opening yourself up to a lot of strife – having a prepayment penalty on your mortgage contract is never a good idea because you simply just do not know what the future will bring.
You must also consider the payment cap. A payment cap sounds great – your mortgage payment cannot go above “x” amount of dollars, however, that doesn’t necessarily mean that the interest charge is capped. If the interest rate raises high enough that you go over your payment cap, the lender may add the interest to your mortgage debt, which then finds you in the position of paying interest on the interest. This can translate to you paying much more for your property than you did when you bought it – this is called “negative amortization”. Many lenders have a cap on negative amortization that you can have, and if you reach that point, your payment cap goes out the window and your mortgage’s monthly payments are adjusted to begin repaying the negative amortization debt.
Factors that can go either way
There are a few factors of adjustable rate mortgages that can fall on either side of the pro/con debate. Due to the fact that there are many different types of adjustable rate mortgages available from different lenders, it’s important that you research the adjustable rate mortgage and find out whether it is right for you. Some of the ‘ambiguous’ factors that you have to consider can make or break the decision to go with an adjustable rate mortgage.
One of the first things you need to consider is the lifetime interest rate cap on the mortgage. This is the maximum amount that the interest rate can raise through the period of the mortgage. There are also the periodic adjustment caps that limit the amount that your mortgage interest rate can raise from one adjustment period to the next.
Most lenders use one of the index rates to base their interest rates on. The index rates change and fluctuate with the movement of the economy. To determine the interest rate that you will be charged, the lender adds a margin (profit percentage) to the index rate. The margin that the lender will add is also important – it determines your future interest rates with an adjustable rate mortgage. The margin is different from lender to lender, so it’s important to find out what the margin is.
Summing it Up
Don’t assume a fixed rate loan is better or worse than an ARM. Each has an appropriate use in real estate investing. In short, do your homework, read the fine print, and get the best, most economical loan that fits your investment strategy.
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Attorney William ("Bill") Bronchick, host of Legalwiz.com, has authored six best-selling books and is sought nationwide for his 25+ years of real estate and legal knowledge. He has been interviewed by numerous media outlets, such as CNBC, TIME Magazine, USA Today, Investor Business Daily, Forbes, and the LA Times, to name a few. William Bronchick is the co-founder and past President of the Colorado Association of Real Estate Investors and the Executive Director and founder of the College of American Real Estate Investors. Click on the "About" link above for more information on William Bronchick.