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Advantages and Disadvantages

Advantages. With adjustable-rate mortgages, your mortgage interest rate goes up and down. If rates are high and likely to fall, this is an advantage. If rates are low and likely to rise, this is a disadvantage. ARMs have some other attractive attributes, but interest- rate forecasts should be the major factor in deciding whether or not to get an ARM.

If you think rates are going down, consider an ARM. If you think rates are going up, get a fixed-rate mortgage. If interest rates stabilize or fall, an ARM is less expensive than a fixed-rate mortgage over the long term.

The initial interest rate of ARMs is typically 2 percent to 3 percent lower than traditional fixed-rate mortgages. ARMs are generally more affordable in the first two years, and you do not need so much income to qualify for an ARM as for a traditional fixed-rate loan.

Some ARMs are assumable (see Chapter 6, “Miscellaneous Mortgage Topics,” for an explanation of assumability). This could make it easier to sell your home if interest rates increase.

Disadvantages. With an ARM, your mortgage interest rate and monthly payment can and probably will go up sometime during the life of your loan. In the hypothetical example, the ARM's initial 5 percent rate in year 1 rose to 10 percent in year 6. That kind of increase in rate would cause a 65-percent increase in your monthly payment even with all of the protective caps. Few household budgets can absorb that kind of mortgage payment increase without feeling a pinch.

In 2000, the One-Year Treasury Security Index (the most common ARM index) started at 6.12 percent and fell to 1.01 percent by June 2003. By the end of 2005, it was back up to 4.35 percent. Over the ten years from 1981 to 1990, it ranged from a low of 5.5 percent to a high of 17.2 percent. Overall interest-rate levels may go lower than they are today, but based on past history, rates have a lot more room to go up than down. Predicting interest rates is difficult for even the most skilled economists. It is even more difficult if you are betting your mortgage payment on your predictions.

Before you decide to get an ARM, be sure to get answers to the following three questions:

• If interest rates (and the ARM's index) stay at the same level as today, what will the monthly payment be after one year? Two years? Three years?

• If interest rates (and the ARM's index) rise precipitously, what will be the maximum monthly payment that you might possibly have to pay? Can you afford it?

• Will there be negative amortization that increases the loan?

You need to answer question 1 because those are the payments you will most likely be making. Usually, these payments are disclosed on your preliminary and final Truth-in-Lending disclosures provided to you by your lender.

You need to know the answer to question 2 because this is the worst-case scenario. If you keep your home for 30 years, rates will rise dramatically at least once or twice during that period. To calculate the maximum payment in a worst-case scenario, calculate the maximum interest rate (initial interest rate + life interest rate cap) and multiply your loan amount by the mortgage payment factor (found in Appendix I) for the maximum rate to determine the maximum payment.

You should feel comfortable that you can afford the expected payment increases (question 1) as well as the worst-case payment increases (question 2).

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