When should you opt for an Adjustable-Rate Mortgage?

Interest rate differentials alone are not enough to justify using an adjustable-rate mortgage (ARM) over a fixed-rate loan. The deciding factor should be determined by analyzing and comparing the overall savings between loan programs. As a very broad and general rule of thumb, if you can save at least 2½ percent in interest and you intend to own the property for less than four years, it may be worth your while to choose the ARM. It follows, then, that the smaller the gap between the fixed and adjustable rates, the less attractive an ARM becomes. But there are a number of other variables to weigh in selecting a loan, such as the up-front costs of borrowing using each type. Some questions that you should seriously consider when making your choice include:

• What is the history of the particular index used by the lender? Ask to see historical documentation.
• Where do economists think interest rates are currently headed? If up, your interest savings may not be as great as you thought. If it's down, you may have an even bigger savings windfall than anticipated.
• What are the terms of the loan? When does the ARM payment adjust? How will the new rate be figured? What are the maximum amounts that the payment could rise or fall to?
• What's the lender's margin? Because this value remains constant for the life of the loan, it has as much (if not more) impact on where the rate adjusts to as does the index.
• Is there a convertibility option? If so, what's the cost to utilize it? Be sure to take into consideration any higher interest rate on the loan as well as all conversion fees. Also ask how the fixed rate will be determined at the time of conversion. To answer these questions, be sure to obtain a completed copy of the ARM loan disclosure form. If you have difficulty weighing the options, seek the expertise of an experienced financial adviser.
• What are the loan's up-front costs? Do they offset any potential interest savings? Is there any creative way to finance the costs into the loan to eliminate out-of-pocket cash at closing? If there is, how will it affect the monthly payment and any future resale value?
• Is the lender going to hold the loan in its own portfolio or sell it in the secondary market? If they'll be holding it, how might that benefit you?
• What are your goals in buying the property? If you're looking for rapid equity buildup, you should stay away from any product that allows negative amortization. However, if you're a first-time homebuyer who just barely qualifies, perhaps a low introductory rate or adjustments that occur every three or five years might suit you well.
• How long do you plan to own the property? Short-term owners should consider a loan with good assumability, a slow-moving upward index, low up-front loan origination fees, a low down payment, and no negative amortization. Long-term property owners, on the other hand, may be well-advised to avoid ARMs completely. But if you do choose an ARM, be sure to select one with a good convertibility option and low conversion fees. Further, index and margin are also very important to long-term owners, who also could use more leverage at the outset (including negative amortization, although this is strongly discouraged) because they have more time to recover any lost equity.
• Who else will participate in the purchase? If there's only one purchaser, then virtually all ARM programs will be available, because many ARM programs sold into the secondary market won't allow co-borrowers. Among those that do, each has its own strict guidelines.
• How much of a down payment will you be making? If you want to make only a small down payment, PMI insurance will be required, as will an immaculate credit report, a strong income base, and cash reserves of at least two or three months. Due to extreme leverage you'll be using, you'll have limited negotiating power with the lender.

  On the other hand, if you're prepared to make a large down payment, you may find a somewhat easier time qualifying, and you'll be in a stronger position to negotiate for lower margins and origination fees and to request paying taxes and insurance outside of escrow.

• How much of a monthly payment will you be able to handle? Consider both affordability and desirability issues. For most ARMs, the housing ratio (depending on which investor buys the loan) must use no more than an approximate maximum of 28 percent of gross income, and the total debt ratio – including all debts of ten months or more plus the principal-interest-taxes-insurance (PITI) payment – must not exceed approximately 36 percent of gross income.
• Would you be averse to fluctuating payment amounts? If the answer is "yes," then you should not seriously consider any type of ARM. If you answer "no," you could choose a financially and emotionally preferable frequency of payment adjustment (for instance, every year; every three years, five years, or ten years) and then select the type of loan to match.
• What current assets, including personal and real property, do you have that could be mortgaged, liened or sold to raise extra collateral cash if needed? If your debts are low, then you could borrow against an asset, but repayment would likely be factored into your long-term debt ratio. Additionally, an asset may be converted to cash to use as additional down payment money in order to negotiate a lower margin or cap.
• What are your short-term and long-term liabilities? Balances are needed to determine this, as well as repayment schedules. If you have a high number of credit accounts and small liabilities, you may not be able to qualify for a high loan-to-value ARM, or you may have to pay off and close some of the accounts in order to qualify. However, if you have few debts, but are short on down payment or cash reserves, you might consider obtaining a gift letter or borrowing from a low-interest source, such as life insurance or a credit union.