Adjustable Versus Fixed Rate Mortgages

Adjustable Rate Mortgages are not only risky but are more expensive than fixed rate mortgages

In today’s market the interest rates on adjustable rate mortgages are higher than the fixed rate mortgages. While this doesn’t make much sense, market conditions are such that this is the current situation. Therefore, there is no benefit for a homebuyer to borrow money using an adjustable rate mortgage, period.

So when does it make sense to take an adjustable-rate mortgage?

Neil Bader, CEO of Skyscraper Mortgage in New York, says, its “when the spread between a fixed-rate mortgage and an adjustable-rate mortgage increases to the point that there are significant savings in payments.”

For example, if today’s one adjustable-rate mortgage was at 4.00% and a thirty-year fixed-rate mortgage is at 4.90%, the savings would be about $70 per month for a $100,000 mortgage. However in today’s market, the fixed rate is 4.9% and the adjustable rate is over 6%.

There are balloons, convertibles, and all types of adjustable-rate loans: 2/6, 1/5, 1/4, 3/1, 5/1, 5/5, 7/1, 10/1. All are currently priced above the fixed rate mortgage.

Here’s some more information about adjustable-rate mortgages that you should know. First, they may have interest rates that adjust monthly, semi-annually or annually. Some mortgages only adjust once during the entire life of the mortgage. However, most adjustable-rate mortgages are adjusted annually after an initial fixed period of one, three, five, seven or even ten years.

Another difference in adjustable-rate mortgages is the amount of interest rate adjustment permitted at each adjustment period. This is called a cap. Most common are mortgages with 2/6 caps for shorter terms and 2/5 for longer terms. The first number refers to the maximum increase at each adjustment period. The second refers to the maximum interest rate increase during the lifetime of the loan.

You will also want to know exactly how your interest rate will be determined. There are two parts to an adjustment. First is the margin. This amount will be added to the index to compute your interest rate for the adjustment period. Margins can vary from 2% to 3.5%. A higher margin can mean a higher interest rate.

The second part of the adjustment formula is the index. This is the number added to the margin in order to determine your new interest rate. The index is usually based on a four-week average of the one-year Treasury bill rates. Other indexes include the 11th District Cost of Funds or the LIBOR six-month rate.

All lenders are required to give you an adjustable disclosure booklet describing adjustable-rate loans and how they work. Be sure to read this information before you apply for a mortgage. Also ask for a disclosure on the type of mortgage you are considering. It will provide the details of what you can expect when interest rates adjust.

And what about conversion options? Some adjustable-rate mortgages carry an option to convert to a fixed-rate mortgage at some future date. You might pay more for a conversion option, and there is no real advantage to a convertible mortgage because of the low cost of refinancing. Conversion rates are very tricky. It is better to refinance when you can select the rate you want.

And one last word of advice. Adjustable rate mortgage loans can be very complicated because of all the variables. Do not accept verbal promises from the lender’s agent without also getting it in writing. If after reading the material provided to you, you still don’t understand something, ask questions.