18 April 2006, Revised November 12, 2008
In general, ARMs have lower payments in the early years than FRMs but
expose you to the risk of higher payments in future years.
Select an FRM if you can afford the payment, and a) expect to have the
mortgage 7 years or longer, or b) have a strong preference for payment
stability. Select an ARM if you cannot afford the payment on an FRM, or
if you confidently expect to be out of the house within 7 years.
If you might be out of your house within 7 years but aren’t sure, the
decision process is more difficult. In assessing it, you must balance
the rate savings on the ARM relative to an FRM during the initial rate
period of the ARM, with the risk of rate increases when the initial rate
period ends – if it turns out that you still have the mortgage at that
point. The rate saving is the FRM rate less the ARM rate at about the
same number of points.
You can quantify the risk of rate increases after the initial rate
period ends with calculator 7b (
Monthly
Payment Calculator: Adjustable-Rate Mortgages Without Negative
Amortization.) For your ARM, you must know the current value of the
index, margin, rate adjustment cap, and maximum rate. You must also
specify an assumption about what happens to interest rates. The
calculator will give you several options, including the “worst case”
possible. The worst case has a very low probability of occurrence, but
it is nice to know you could manage it.
For a detailed illustration of a comparison, see
Choosing
Between Fixed and Adjustable Rate Mortgages.
You can also check out a strategy used by some astute borrowers, which
is to take an ARM but make the payment that they would have made had
they taken an FRM. By paying the ARM balance down faster, the cost
imposed by rising rates in the future, if you still have the mortgage,
is reduced. You can check out an ARM using this strategy at
ARM Tables
Tutorial.