An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate stays 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.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than would be 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 pose the problem they do 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?
What is the initial rate?
How long will that rate stay in effect?
How is the adjusted interest rate determined? (Generally, a specified amount—the “margin”—is added to a current published rate—the “index.”)
How often can the rate change?
How much can the rate go up each year and over the life of the loan? What is the maximum monthly payment you could be required to pay? Would you be able to afford it?
Does the loan set a minimum interest rate?
Do the monthly payments gradually decrease the amount you owe even if interest rates increase? (With some loans, the amount you still owe can increase rather than decrease each month—called “negative amortization.”)
Does the interest rate increase if your payments are late?
Could you qualify for a loan with the maximum interest rate permitted under the mortgage? If not, do you anticipate earning more in the future so you will be able to afford the higher payment?