Why an ARM may be still the best bet

Are you feeling a little panicky because interest rates are going up and you aren't locked in? Perhaps you just got that great home and your first adjustable rate mortgage (ARM) and are thinking, "Oh, oh." Maybe you are even thinking about refinancing. Many mortgage experts would recommend that you hang tight, especially if you aren't going to stay in your home past your initial "locked in" rate on your ARM. Why? The amount of money you are saving on your low initial rate can really pay off, especially if you aren't planning on staying in your house for too long.

That low initial rate is called a "teaser rate". It's the incentive that the lender gives you to take the ARM in the first place. However, you might want to know more about the other factors which affect your ARM:

Index: This is the variable rate used as a base to establish future rates of the mortgage loan. The index could be taken from various market rates depending on your mortgage lender. In effect, the index is the lender's attempt to predict what the interest market will be doing over time.

Margin: This is the spread between the index and what you pay. It's the lender's "mark up" on the money you borrow. For example: If the index is based on One Year Treasury Bills at 3% and the margin is set at 2%, your rate would be 5%.

Margin Adjustment Period: This is the time period when the interest rate on your ARM is fixed. If the adjustment period is one year, then the interest rate will remain fixed for one year, after which it will begin to be adjusted according to the current index and margin, usually on a yearly basis.

Adjustment Cap: This is the maximum the interest rate can adjust either up or down for each adjustment period. This cap can make a big difference. It can limit your exposure to higher rates.

Lifetime Cap: The maximum mortgage borrowing rate charged over the duration of the adjustable home loan. This is also very important, especially if you are planning to be in your home for the duration of the mortgage term. In most cases, you'll want the lowest possible lifetime cap.

Conversion Options: Now, this is where some folks try to "play" the interest market, like others play the stock market. They hope to be able to "time" interest rate hikes, and lock in at the right point. How do they do that? Well, your ARM may come with options to convert it to a fixed rate mortgage based on a pre-determined formula, but only during specific time periods. For example, the 1-year Treasury bill adjustable could be convert to a fixed during the first five years on the specified adjustment date. Meaning, you have the option to convert in the month of the 'anniversary' of your loan, every year.

So, should you convert? This is where you are playing the interest market. If your adjustment cap and lifetime cap are low, and you know you can handle those payments, it's not likely time to convert. Keep in mind that if your initial rate is quite low, you are saving a bundle on interest. You might even want to put some extra money against the principal while you are saving money. This can really pay off big in the long term. Also, if you don't expect to be in the house past the initial "teaser rate" time period, you shouldn't consider converting.

If you are planning to be in your home past your initial teaser rate period, you may want to lock in now, especially if you have a 10 year ARM. Interest rates are moving out of historic lows, and if you can get a good locked-in rate, it will give you predictability on the size of your payment for some time to come.

Unfortunately, no one can be absolutely sure where mortgage and interest rates will go over the next few years. It is a gamble. So you have to decide how and where to gamble, based on your tolerance for risk. If you need your payments to stay in a predictable range, or your job may not be as secure as you'd like and payment amount is an issue, lock yourself in. If you have a good secure job and are expecting regular pay increases over the next few years -- in other words, you can afford to gamble -- then you might want to stick with your ARM.

Michael

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