Adjustable Rate Mortgages: What you need to know

If you’ve been trying to buy a house you may have noticed there are a lot of numbers to consider: the price of the house, your savings, the amounts of the down payment and monthly payments you can afford, as well as a host of other figures and fees. Trying to find a mortgage that meets your needs is another numbers game, but this one can work in your favor.

You may not realize it, but there is great variety available to home buyers shopping around for a suitable mortgage. Different banks, brokers and other lending institutions all offer their own mix of short-term and long-term mortgages, as well as both fixed rate and adjustable rate mortgages.

So how do you know which combination is the best for you? That depends on your circumstances.

Traditional fixed rate mortgages allow you the security and stability of knowing that your mortgage interest rate will not fluctuate with market conditions. This means that if interest rates spike, you will be protected. Conversely, if interest rates drop, you will not be able to take advantage of the potential savings without transferring your mortgage to another institution or making other possibly complicated arrangements.

Adjustable rate mortgages (also known as variable rate mortgages), are different than fixed mortgages in that the interest rate you pay on the outstanding principal of your loan fluctuates according to changes in the posted index rate. There is a certain amount of risk involved with an adjustable rate mortgage in that you may end up paying more money in the long run if interest rates rise and stay high. You also have the potential to take advantage of savings if interest rates fall. An additional bonus to adjustable rate mortgage is the lower initial interest rate. You may be risking higher or unstable payments, but you are rewarded with a lower interest rate when your loan is at its fullest point. Unless interest rates rise dramatically, this advantage is likely to save you more money than if you had chosen a fixed rate mortgage.

There are advantages and disadvantage to securing an adjustable rate mortgage loan. However, you may find an adjustable rate mortgage worthwhile if you intend to pay off a large portion of your outstanding balance early into your loan period. By doing so, you reduce the bulk of your loan while paying the initially lower interest rate. An adjustable rate mortgage may also be the best choice for you if you anticipate greater future income or if you intend to pay off the entire mortgage loan quickly – again due to the lower initial interest rate. Even if rates were to increase early into your mortgage period, the fluctuation would unlikely be so great that it negated the difference in interest rates between a fixed rate plan and a variable rate plan.

You can reduce the financial risks associated with an adjustable rate mortgage by asking your lender about interest rate ceilings or caps that protect mortgage holders from sharp increases in the amount of money they must pay each month (or whatever their payment period is: monthly, weekly, bi-weekly, etc.). The overall ‘ceiling’ restriction is legislated in almost all cases, and it limits the total possible interest rate increases over the period you hold the loan. Periodic caps help control interest rate hikes between adjustment periods.

Your lender may also be willing to consider payment caps, which stabilize your monthly or periodic payments so any interest rate fluctuations are worked into your payment by way of adjusting the ratio of principal to interest each payment covers. This is a great option if you have limited income flexibility, but could result in a negative amortization period over the long haul. This happens when the balance of your mortgage is actually growing rather than shrinking because your regular payments are not large enough to pay all the interest plus a portion of your outstanding principal.

A final option to consider is arranging to have the ability to convert your adjustable rate mortgage into a fixed rate mortgage at a designated time. You may pay a fee for converting your mortgage, but if you find yourself in a situation where interest rates are rising rapidly, it may be worthwhile to stabilize your payments and balance by switching to a fixed rate plan.

Speak to your financial advisor to find a mortgage plan that fits your budget and your needs.