Q&A on Adjustable Rate Mortgages

brianoconnell

Mortgage rates are at a race to the bottom this week, with many brokers closing deals for homebuyers in the 2.50%-to-2.75% interest rate range right now.

That begs a good question. If traditional 30-year fixed rates are that low, what can you get for an adjustable-rate mortgage, which historically offers lower rates? Probably a good deal in the short-term - with major financial risks later on, lenders say.

Recently, we chatted with Dr. Guy Baker, a mortgage expert and founder of Wealth Teams Alliance in Irvine, Cal. Here's the Q&A - it sheds some good light on the pros and cons of getting an adjustable-rate mortgage deal these days.

KTE: Briefly, what is an adjustable-rate mortgage?

Dr. Baker: An adjustable mortgage means the interest rate is not fixed for the life of the loan, in most cases. This means after a guaranteed period, the interest rate can rise. 

The risk of having your interest rate (and monthly payment) rise on your mortgage is a recipe for disaster for many homeowners. They build their lifestyle on a certain income - making purchases and committing to payments they might otherwise eschew. When the rates rise, the payment increases, suddenly they could be underwater every month.

KTE: Adjustable-rate mortgage vs. fixed-rate mortgage: What's the difference?

Dr. Baker: The fixed-rate mortgage gives you a set amount of money to pay every month on a mortgage. It's like renting an apartment with rent controls. The rent can never go up. 

An adjustable mortgage different is like living in an apartment in which the landlord can raise your rent every year, once the mortgage payment grace period ends (usually that's three-to-seven years with ARMs.)

Fixed-rate comes in two sizes - 15-year and 30-year timetables. They are based on having no mortgage left to pay at the end of the term. In contrast, an adjustable mortgage means you will be required to pay off the mortgage - but you don't know how much you will pay in total interest.

KTE: When are adjustable-rate mortgages a good idea? When are they a bad idea?

Dr. Baker: Some adjustable mortgages will set the variable rate for up to seven years. This can get a young family into a house earlier than they thought possible. 

The risk is you can't afford the mortgage at the end of seven years, if the interest rates rise. With a fixed-rate mortgage, you can lock in the rate for the life of the loan. Plus, with a fixed mortgage, if interest rates fall, you can refinance and lock in a lower rate. 

If you're in an ARM and rates rise significantly, the downside is that you might not qualify for another loan. So, you might get stuck with a high-interest mortgage because they didn't opt for a fixed-rate mortgage.

KTE: Should Main Street consumers get an adjustable-rate mortgage?

Dr. Baker: I would advise against it today. 

Fixed rates are below 3% right now - this is unprecedented in our lifetime. We know interest rates will eventually have to go up. When they do, we could see rates move into the 5's and even 6's. I have seen 7's and 8's in my career. 

Locking in at 3% or less for a fixed-mortgage is amazing.