When Does it Make Sense to Use an Adjustable Rate Mortgage to Purchase Your Home?

With the rates on fixed rate mortgages moving higher over the last few weeks, adjustable rate mortgages (ARMs) are suddenly popular again. Right now there is a huge spread between the rate on a 30 year fixed rate mortgage, and a 5-1 ARM, which is fixed for the first five years before it can adjust. The difference in rate now is 7/8s of a point, which is mind boggling huge. On a $300,000 loan this comes out to a savings of $166 per month. This spread means a home buyer here in the Chicago area can save thousands of dollars in payments by going with the adjustable instead of the fixed rate. But the savings come at a cost. By taking on an ARM, you are taking a risk that rates may be higher down the road, and if you are still in your home, and still in your mortgage, your payments would then move up.

Does it make sense to take the risk? If you've been following the news, there is lots of talk about the housing slump, and one of the mainstays of these stories is about the dangers of adjustable rate mortgages. There is no doubt that people have gotten in over their heads, and in some cases ARMs have been part of the problem. (A bigger part of the problem might be that they didn't understand what they were getting into.) ARMs aren't as dangerous as some think. They aren't for every person or every situation, but used correctly they can be a great option.

So when does it make sense to choose an ARM?

1. When you don't expect to be in the house for the long term - Most home buyers go with fixed rate mortgages because they feel safer taking on a mortgage where the rate and payment will always stay the same. But most people don't stay in their homes for 30 years, especially first time home buyers. With job transfers, changes in life style and upward mobility, it is now common for homeowners to move after five to seven years. ARMs come with fixed periods for the first 5, 7 or even 10 years. Why pay extra for time you don't expect to be in the home?
2. When you don't expect to be in the mortgage long term - This one is harder to anticipate, but most home owners don't keep the same mortgage, even if they stay in the house long term. Interest rates go in cycles, up and down. Refinancing used to be prohibitively expensive. Now no-cost refinancing (we pay all the closing costs by increasing the interest rate slightly) is common. Now if the mortgage rate drops by a half a point it makes sense to lower your payment by refinancing. Mortgages are now looked at as more of a financial planning tool. If you build up equity in your home, you may want to tap into that equity with a new loan. Again, if you think it is likely that you will refinance your mortgage in the next 5 - 7 years, an ARM may be a good option.
3. When you expect that your income will be increasing - This is the case with a lot of first time home buyers. If you are early in your career and expect that your income will be moving up, you are in a position to accept a little more risk that your payment will be higher down the road. By taking on an ARM you are able to take advantage of the savings now, when you need it most.
4. When you want to build up equity quicker - You can use adjustable rate mortgages to build up your home equity or as a way to increase your investment. One way is to pay the same mortgage payment you would make if your loan was fixed. If you did this with the example I used earlier and paid the $166 saving as an extra principal payment each month, you would pay down an extra $14,000, building more equity than you would with the 30 year fixed rate. Another way to approach this is by taking the savings and investing it in an outside investment where you can earn more than the mortgage interest rate. If you plan on doing this, you need to make sure you consistently add to your investment each month.

Those are a few reasons why you might consider an ARM, but for some people adjustable rate mortgages are the wrong way to go. Don't take an ARM if you meet any of these criteria:

• You plan on staying in the home for at least 10 years.
• Your income is not going up, and you would have trouble making the payment if the mortgage payment goes up when the loan adjusts.
• You can't afford the home if you don't use the ARM.
• Taking on the extra risk will make it hard for you to sleep at night.

Whether an ARM is right for you depends on your own personal and financial situation as well as your goals and expectations. But ARMs aren't something to be afraid of, and for many people they are a great way to save money. If you have any questions, or if you want to go over your own situation and see if an ARM would work for you, let me know.

Pete Thompson is an Illinois mortgage banker who provides superior mortgage service and competitive mortgage rates in Chicago, the Chicago area and throughout Illinois. Click here for a Free copy of The Real World Home Buyer's Guide - How to Save Thousands when Buying a Home and Getting a mortgage. For information on the latest mortgage news and current Illinois mortgage rates, please visit http://www.illinoismortgageratesandnews.com