When you get a loan to buy a house, you can choose a fixed-rate or an adjustable-rate mortgage. A fixed rate means the interest rate stays the same for the life of the loan. An adjustable-rate mortgage (ARM) has a variable rate.
Most ARMs provide lower interest rates at the beginning of the loan, and then the rate varies depending on the index it is tied to. If you’re buying a house that you’re sure you will only be in for a few years, you can usually save a significant amount of money with an adjustable-rate mortgage.
Some ARMs have fixed rates for the first year (or even the first several years), but eventually the rate changes. The amount of the change depends on the index and the margin of the loan. Lenders often use the U.S. Prime Rate as their base lending rate, then add a margin based primarily on the amount of risk associated with a loan. Other common indices include the 10-year Treasury bill, the cost of funds index (COFI), and the London Interbank Offered Rate (LIBOR). Margin is a specified rate above the index, usually 1 to 3 percent. This margin gives the bank the incentive to lend money to you or me and not just buy treasury bills at the index rate.
Before you sign on the dotted line, be sure you understand which index your adjustable interest rate is tied to and what the margin is. Some indices are more volatile than others.
Try to avoid the temptation of low interest rates associated with an ARM if you don’t plan to move in the next few years. While telling themselves, “I’ll probably move,” people sign up for the ARM and then get stuck with higher interest rates than they would have if they had started with the fixed-rate loan.
This is especially true when the ARM begins with an introductory rate that’s a teaser rate—a rate that isn’t fully indexed. Let’s say your loan is tied to the LIBOR at 2 percent with a margin of 2 percent. That would make the fully indexed rate 4 percent. An introductory rate less than 4 percent is a teaser rate, and people fall for teaser rates all the time.
If you qualify for the ARM based on a teaser rate, but you will not be able to afford the mortgage when the rate becomes fully indexed, this is not a good plan. However, if the initial interest rate allows you to qualify for the loan and you know your financial circumstances are about to improve (your spouse is returning to work once Junior goes to kindergarten next year, for example), then it’s fine.
The best way to figure out which type of loan is right for you is to work with your Realtor and a local lender. Be up front about your financial resources and your plans as they relate to your income. Lenders have many loan programs to choose from, so the more information you provide, the better they can help you find a loan that best meets your needs.
If you have questions about real estate or property management, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.