Adjustable VS Fixed-Rate Mortgages

Even as they inch up a bit, today's mortgage rates still look like a bargain.

Back in September, 1981, the FHA (which used to set nation-wide interest rates for all the mortgages it insured) was asking 17.5%. And people who needed to buy, were paying rates like that in the early 1980s. (We can only hope they've paid off those loans early refinanced to something a bit lower by now.)

Those were the days when bankers, trying to find something people could afford, and wishing they could get free of old 5% loans, invented all sorts of new mortgage plans: graduated payment plans, rollover mortgages, shared equity loans, pledged account mortgages. And when the dust had settled, the new arrangement that became part of the standard array of mortgage offerings was the adjustable rate mortgage.

The adjustable rate mortgage shifts the risk of changing rates to the borrower. If rates in general fall, the borrower can benefit next time the monthly payment figure is adjusted. If rates rise, so does the borrower's interest.

And to make the plan attractive to homebuyers, the adjustable rate usually carries an appealing initial interest rate, lower than average current levels. To some homebuyers, this looks like a "come on, the first one's free" ploy. They inquire "what would my payment be if this were adjusted to the rate your long-time borrowers are paying by now?" And they usually opt, these days, for fixed-rate loans, to lock in today's relatively low rates for the next 25 or 30 years.

But there are some buyers (a minority these days) who choose adjustable rate mortgages (ARMs) for good reasons.

Certain ARMs won't adjust for long periods. The low initial rate may last for three years, five years, sometimes even seven years. The buyer who doesn't expect to live in the house any longer than that may jump at the lower monthly payments.

It's always prudent to ask, however, what happens to the shortfall when the payment doesn't cover today's true cost of money. In a few instances, the money that isn't being billed is added to the amount of the loan -- a condition called negative amortization. At the end of the year, the borrower owes more than at the start. Again, though, even that might not worry the buyer in an area where prices are skyrocketing, so that the sale will more than take care of the problem of paying off the higher loan.

For someone who anticipates rising income (a professional just starting out, for example), qualifying for the lower rates on an ARM can mean borrowing more and thus buying a more ambitious house.

And if rates ever shoot up to 17% again? We'll face that problem when we come to it.

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