How to compare adjustable rate mortgages

Mortgages in general can be very confusing to most homebuyers, this is why it is important to understand the process before purchasing a home. You do not want to be pressured into making the most important financial decision you will ever make in your life.

Adjustable rate mortgages are becoming increasingly popular so the need for comparison of these products has become very important. Adjustable rate mortgages typically have an initial fixed rate lower than the rate of a comparable fixed rate mortgage. The initial fixed rate period is followed by adjustment intervals.

While traditional fixed rate mortgages (FRMs) are very easy to compare, adjustable rate mortages (ARMs) take a great deal of understanding to effectively evaluate. The problems are two fold; first comparing the effective cost of borrowing requires a complex financial calculation and secondly to compare the privileges and features you have to understand what they all mean as well as know the right questions to ask.

When financing with an Adjustable Rate Mortgage (ARM) make sure that you do not have a pre-payment penalty that is longer than the fixed period of your loan

Fixed-Rate Mortgage: A loan with an interest rate and monthly payment that stays the same over the entire term of the loan.

1. Don’t be fooled by low introductory teaser rates or prime discounts

Try to determine the cost of borrowing until such time that the mortgage becomes open or is renewed. Low introductory rates that are offered may make it beneficial for you to switch banks every few years. Effectively compare rates offered on ARMs by determining the average cost of borrowing for the period until the mortgage is fully open or renewed.

To do this you need to do a weighted average calculation that will give you the effective cost of borrowing. A weighted average calculation can be done by (a) multiplying the introductory rate by the number of months it is in effect (b) multiplying the rate after the introductory period by the number of months until the mortgage becomes open (or renews) and (c) taking the total from (a) and (b) then dividing this number by the total number of months in (a) and (b).

2. Understand the conversion options and rate discounts

Some mortgage brokers sell their clients on the idea that you can convert an adjustable rate mortgage to a closed term mortgage with any penalty at any time. Know exactly what the rate discount will be if you convert. If it costs you three months interest to switch to another financial institution they have you trapped when it’s time to negotiate your closed term rate. Make sure that when you convert to a closed term you will get a good discount on the closed rate, otherwise be prepared to stay variable until it becomes open or renewed.

3. Know how rate changes will affect your payment

Some adjustable rate mortgages have payments that adjust as prime moves while others do not. These adjustments are determined by a margin (a fixed number set by the lender). When prime goes up and your payment stays the same, then the portion of your mortgage payment that goes towards the principle is decreased. This means that your amortization period is also extended.

Adjustable rate mortgages can provide attractive interest rates, but your payment is not fixed. This calculator helps you to determine what your adjustable mortgage payments may be.