An adjustable–rate mortgage (ARM) differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate and the monthly payment of principal and interest stay the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
To compare two ARMs, or to compare and ARM with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps on rate and payments, negative amortization, payment options, and recasting (recalculating) your loan. You need to consider the maximum amount your monthly payment could increase. Most importantly, you need to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments.
Lenders generally charge lower initial interest rates for ARMs than fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook, than a fixed-rate mortgage for the same loan amount. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage – for example, if interest rates remain steady or move lower.
Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It’s a trade-off- you get a lower initial rate with an ARM in exchange for assuming more risk over the long run. Here are some questions you need to consider:
- Is my income enough – or likely to rise enough – to cover higher mortgage payments if interest rates go up?
- Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
- How long do I plan to own this home? If you plan to sell soon, rising interest rates may not post the problem they might if you plan to own the house for a long time.
- Do I plan to make any additional payments or pay the loan off early?
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