The Lure of Adjustable Rate Loans – Top Tips To Protect Yourself
With interest rates rising, more and more of us are considering adjustable rate loans. So what do you need to know if you or a loved one is concerned about rising interest rates? How do you know if an adjustable loan is the way to go? And why are folks trending back towards adjustable rate loans again?
Let’s start where we left off with adjustable loans…weren’t those the types of loans that caused millions of people to lose their homes over the past few years? Adjustable rate loans got millions of folks into trouble only a few short years ago. But the homeowners, not the loans themselves are the reason for that. In fact adjustable rate loans, used well, can be valuable tools that can save you a lot of money. That’s because they’re less expensive than fixed rate loans. And that’s because lender prefer to give adjustable loans over fixed loans. With fixed loans, lenders’ money is tied up for a long time. If the markets go up, the lenders are locked in to earning the old low rate. So lenders charge a premium for doing that. And charge less for adjustable rate loans in order to provide is with an incentive to take out adjustable loans. Lenders get paid via interest. So the interest rate on adjustable loans tends to be lower than fixed. As a borrower you can use an adjustable loan in one of two ways. You can either take advantage of the lower cost to have a lower monthly payment. That’s a smart use. Or you can take advantage of it to borrower more money. That’s often not so smart. For example, at today’s rates, if you could afford a $900 per month payment, you could borrower around $170,000 with a fixed loan or as much as $200,000 with an adjustable loan.
So what are some of the things folks should consider in order to be sure that, if they are thinking about an adjustable rate loan, it’s truly the right choice for them? In terms of advantages with an adjustable rate loan is, since you’re paying less interest up front with an adjustable rate loan, you’re paying down more principal and accumulating equity faster. With fixed rate loans it can take ten years before the majority of your monthly payments start being applied towards principal. On the other hand, when those adjustable rate loans increase, the payment can be less predictable, or as many found when the bubble burst, become unaffordable. Generally, if you’re expecting a chuck of money or increases in your income and are in a position to pay off the loan if the rate and payment goes too high or if you don’t plan to stay in the home, then an adjustable rate may be a good fit. But if you’re on a fixed income and plan to stay in the home for more than five years, and tend to not like risk, a fixed rate is probably a better fit. You pay a premium for a fixed rate loan, but it’s worth it if that’s your situation.
If you’re still thinking an adjustable loan may be a good choice for you, here are a few questions you want to ask. First, the most appealing thing about adjustable rate loans is those teaser rates so you want to know how long that will last. The most common are 3, 5, 7 and 10 years. The shorter the period, the better the rate usually is, but of course most folks want that teaser rate for as long as possible. Next you want to know what index (examples: Cost of Funds (COFI), London Interbank Offered Rate (LIBOR) the bank will be using when it adjusts your rate – you can look up that index on line to see how it has performed recently which will help you predict how much you rate may go up when it adjusts. Your bank will take that index and add a few points – called the margin – so you also want to know what the margin is. Once the rate begins to adjust it will adjust again periodically so you want to know how often that can happen. Adjustable rate loans are expressed in terms of how long the teaser rate lasts and then how often the rate can adjust after that – for example a 3/1 or 5/1 ARM means the teaser rate is in place for 3 years or 5 years and then adjusts once per year after that. There are also caps on how much your rate can adjust each time as well as over the life of the loan that you will want to know.
The real reason folks got in to trouble with adjustable rates during the bubble is because they took out loans they could only afford with the teaser rate. They knew once the rate adjusted they would not be able to afford the payment but they banked on being able to refinance when that happened. Unfortunately home values went down and they were not able to refinance their loan so they were stuck with a high payment they couldn’t afford. New laws say you have to qualify for the adjusted rate, not just to low teaser rate. But it’s also up to all of us to make sure we’ll be able to afford payments once the teaser rate goes up – basically assume the worst and you’ll always be safe.