Understanding Mortgage Rates & Arm Mortgages - Tips You Need to Know

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Mortgage rates have declined to historically low rates. Couple that with plenty of real estate homes on inventory and it can be a great time to invest in real estate. In addition to the option of plenty of homes, you now have multiple options to your mortgage as well. For example, aside from the well-known 30-year-fixed rate mortgage, you have the Adjustable Rate Mortgage (ARM) available for your home mortgage.

According to Bankrate the current mortgage rates (as of 8/23/10) are:
30 yr fixed mtg 4.52%
15 yr fixed mtg 3.95%
5/1 ARM 3.51%

So let's break it down so you can understand your options. The low initial interest rate (3.51%) on an ARM sounds great, but you risk exposing yourself to future high interest rates. As a matter of fact, it's important to understand the worst possible case scenario, how much you could have to pay. Do lenders disclose your worst-case scenario? Somewhat. However, they are able to sugar coat it by advertising the initial low rate, which entices many home buyers.

The 3.51% interest rate means you are paying interest only. Not one dime of your mortgage payment will be applied to principal. Is this a negative situation? Not exactly. Keep in mind for the first 10 years or so of a 30-year-fixed rate mortgage very little is applied to principal, especially in the early years. Also, many don't live in their homes for more than 10 years.

Let's assume a 5/1 ARM. Your initial rate according to Bankrate mortgage rates is 3.51%. It's practically 1% less than the 30-year mortgage. For the first 5 years, your rate will be locked in at 3.51% and after every subsequent year, your rate can adjust, say 2% every year. Your maximum cap rate is 6% above the initial rate (3.51%). There is a maximum cap rate and an initial rate. However, for the lifetime of this 5/1 ARM your maximum rate can never be greater than 9.51% (6%+3.51%). Don't forget your mortgage rate can decrease from a previous adjustment, but cannot decrease lower than the minimum. The rates adjust according to a specified index.

Another component to an ARM is the margin. The margin is a constant percentage that a lender will add to the index value. After the initial interest rate period, your new rate will depend on the index value (remember, margin remains constant). Each lender can have a different margin rate.

The Best Approach to an Arm Mortgage: The best approach is to find out what you can afford under a 30-year mortgage and if you can afford your mortgage payment with the maximum rate. If you are able to afford the mortgage at the maximum rate, then you will be better prepared if you were to ever get in that position. Knowing your 30-year-fixed rate mortgage schedule payment you can use that payment towards your ARM. In essence, you will be applying more to your principal, saving you more interest than if you were to choose a 30-year-fixed rate mortgage. In addition, each new adjusted rate is based on the new balance and not the original balance of the loan.

When to use an ARM Mortgage? Use an ARM Mortgage when you don't plan on living in your home for more than the initial rate period. If applicable, be prepared to afford a higher mortgage payment.
· When it's time for the rate to adjust you are able to afford the payment.
· Can afford the mortgage payment if the rate were to adjust to maximum cap rate.

To sum it up, your decision to go with an ARM depends on YOUR financial needs. If you feel you will live in your home for a few years, then an ARM would be suitable. If you plan on living in your home for longer than the initial interest rate period, then be prepared for the adjusting payments (which again could decrease after a subsequent increase in the rate).

If you are uncertain of the length of time you plan on living in your home, then go for a 30-year fixed-rate mortgage and lock in on your interest rate. Either way, rates are historically low. There's never been a better time to invest in real estate.

 Ornella Grosz was recently featured on AOL's WalletPop and is passionate about teaching solid financial planning tips and helping others make the right financial decisions. Grosz holds a BS in Finance and is the author of Moneylicious: A Financial Clue for Generation Y, http://tinyurl.com/29e3g7b Grosz blogs regularly on financial topics at http://www.moneyliciousblog.com. Article is free to be reprinted as long as bio remains.

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