After the last few years the words adjustable rate mortgage scares everyone. However, if you are planning on staying in a home for a short time or you know your financial situation is going to change for the better, an adjustable rate may be the right loan for you. If you are thinking about refinancing but know that you will only be in the home for about 3 to 5 years, a 5/1 adjustable rate may make sense.
The reason borrowers look at the adjustable rate loans is because the interest rate is definitely lower. Right now a 30 year fixed rate mortgage is about 4.875% depending on credit scores, but a 5/1 ARM is about 3.25% for the same loan! That is a savings of over 1.5%! Depending on the loan amount, it could save you over $200 every month. There isn't always such a big gap between the 5/1 and 30 yr mortgage rates, but right now the adjustable rates have not increased as quickly as the 30 year fixed rates have.
Adjustable rate mortgages mean just that – your interest rate can and will adjust. There are different types of adjustable rates. In the past we saw several loans that were 2/28 – meaning the mortgage was fixed for 2 years and an adjustable rate for 28 years – those also usually had prepayment penalties on them. We don't see those loans any more – especially not here in Minnesota. An adjustable rate that has a fixed period of 5, 7 or even 10 yrs may be something to consider. The rates are lower than the 30 yr fixed rate mortgage. Even if you think you may stay in the house longer than 5 or 7 years, you may refinance in that time period. Most people do not keep the same mortgage during the entire time they live in the house.
What you need to be aware of with an adjustable rate is that your mortgage payments can go up. If the mortgage is a 5/1 ARM, that means it is fixed for 5 years. At the end of 5 years, your interest rate will adjust. At that point, the mortgage company has a formula based on the index (sometimes a LIBOR index or the Treasury index), plus a margin and rounded to the nearest eighth. Right now most of the indexes are very low. I talked to a client yesterday that has a FHA adjustable rate loan and his rate has adjusted down from the 5-6% range to the low 3% range! On a 5/1 ARM, the margin is typically 2.25%. So if the index is 2.0%, you add the margin of 2.25% and your new rate would be 4.25%. We know the index will increase in the next few years, but there is also a annual cap on the amount the rate can increase. Most 5 and 7 year ARM's are capped at 2% per year with an initial adjustment cap of 5%. So if you take out a 5/1 ARM today at 3.25%, the most your interest rate could ever increase to is 8.25%.
Do not use an adjustable rate to allow you to buy more home than you can afford. You want to make sure that you are comfortable with the payment even if it goes up to the highest it can go. The benefit for most people is that they don't plan to be in this loan for a long time and they use the lower payment to save money – or pay down the principal even faster as the rate is lower.
If this sounds like something that might make sense for you, talk to your loan officer. A 5/1 or 7/1 ARM may have different qualifications than the 30 yr (down payment or credit scores), but it may be worth looking into. Just make sure you are comfortable with the payments even if they go up!
