hould you go for a fixed-rate or an adjustable-rate mortgage (ARM)? That's a dilemma prospective home buyers face early on in their mortgage application process.

At times in recent history the decision has been easy. When 30-year fixed-rate mortgages hit 18% in the early 1980s, the ARM was the only road to homeownership for many consumers. They could take advantage of the lower rate in the early years of the mortgage, in the hope that by the time they were due for a rate adjustment, the rates would have returned to sanity.

Quite a different situation prevailed as recently as 1998, when consumers were happy to nab a 30-year fixed-rate mortgage for less than 7%. The only direction rates could go, it seemed, was up. So why get an ARM at only a slightly lower rate initially and take a chance on a rate hike later? To many home buyers, the answer was obvious.

But much of the time the choice is far less clear-cut, and such is the case in today's rate environment. By early May 2000, the average rate differential between a 30-year fixed-rate mortgage and an ARM stood at 1.38 percentage points, according to Freddie Mac (or about $95 more in the beginning for a $100,000 fixed-rate mortgage). In August, the differential was .84 of a percentage point (or about $60 more a month for a $100,000 fixed-rate mortgage). It's anybody's guess how this will play out in coming months.

So, should you consider an ARM? The answer requires scrutiny of your mortgage options and your intentions as a homeowner. To help you sort out your choices, here are several frequently asked questions (FAQs) about ARMs.

    Additional information:
    See "Credit Union
    Consumer Facts
    Buying Program"
    for more information
    about buying a house.

How much will an ARM rate change?
Three factors enter into this: index, margin, and rate caps. The ARM rate is tied to a financial index. Several possibilities exist, but the most common index used for ARMs is the value of Treasury securities, which changes from time to time. To this index the lender adds a markup, or margin. The index plus the margin determines the interest rate when you first take out the loan. Likewise, at each subsequent adjustment, those two values add up to determine your new interest rate—but another factor comes into play.

Here's where rate caps enter in. Rate caps limit how much a lender can adjust the rates. The periodic cap limits the amount of change at each adjustment, and the lifetime cap limits the change over the life of the loan. A common cap pairing is the "two and six." The rate can change no more than two percentage points at each adjustment, and no more than six percentage points over the life of the loan.

For example, a 7% ARM could climb to no more than 9% at the first adjustment, and to no more than 13% for the entire loan period—no matter what the index and margin add up to at adjustment time. (So, every adjustment period your monthly payment could increase about $150, or about $450 more monthly at the final adjustment than at the beginning of the loan.) Thus, rate caps protect you against huge rate increases. An ARM also may set a floor below which the rate cannot go, should interest rates fall while you have the loan.

    If you plan
    to be in your house
    only a few years,
    you might consider
    an ARM.

How often will the rate change?
Adjustment periods vary widely, from monthly to several years. With a one-year ARM, for instance, your rate changes once a year. Generally, the shorter the interval between rate changes, the lower the interest rate.

What are the benefits and risks?
An ARM offers three main benefits.
  • It carries a lower interest rate, compared with a fixed-rate mortgage, at the start of your loan period when you typically most need the break of smaller monthly payments.

  • Another plus is that you can qualify for a bigger mortgage, allowing you to get more house for the same amount of monthly payment.

  • Also, rates may fall, so you might pay even less later.
The risk is that rates will climb and with it your monthly payments, perhaps to a point beyond your comfort zone. Your payments could surpass what you'd pay if you locked in to a fixed-rate mortgage at the outset.

What's a hybrid ARM?
This type of loan blends features of ARMs and fixed-rate loans. A hybrid ARM offers a fixed rate for a time period, usually three, five, seven, or 10 years. Then the loan becomes a regular one-year ARM for the remainder of the 30-year term. You'll see hybrids denoted as 3/1, 5/1, and so on.

The hybrid's fixed rate will be lower than that of a 30-year fixed-rate mortgage, but higher than the interest rate on a conventional ARM. Also, the fixed rate rises with longer fixed-rate periods. In other words, the fixed rate on a 3/1 is less than that for a 5/1, which has a lower rate than a 7/1, and so on. The interest rate during the fixed-rate period ties to no particular index. So you'll see lots of pricing variation in the market.
    Fixed or
    adjustable rate?
    The decision
    isn't clear-cut
    in today's
    rate environment.

What about ARMs that offer monthly payment caps, rather than rate caps?
Proceed with caution. The difference between the capped payment and what you would really owe (if there were no cap) doesn't just vanish. It gets added on to what you owe, so the loan balance climbs a little with each payment period. In time you could end up owing more than you originally borrowed.

Which home buyers are prime candidates for an ARM?
Buyers who want or expect to stay in their home for the long haul usually are best suited to a fixed-rate mortgage. So is someone who'd lie awake at night worrying about interest rate hikes.

But if you plan to be in your house only a few years, you might consider an ARM. Perhaps your company transfers you often, or you're starting a family and are sure you'll need a bigger home in a few years. You might be able to find a traditional or hybrid ARM that's tailor-made to fit your moving plans.

Can I convert from an ARM to a fixed-rate mortgage later on?
Perhaps. Ask the lender if this is possible. If so, find out if there is a set time at which you must convert and what the costs would be. Weigh those costs against the interest rate savings you'd gain while the ARM is in effect. And are you certain you'll be able to qualify for a fixed-rate mortgage when you want it?
    A hybrid ARM
    blends features
    of ARMs and
    fixed-rate loans.

How can I compare the costs of an ARM to a fixed-rate mortgage?
Home & Family Finance Online offers a calculator to help you compare different financial scenarios involving ARMs and fixed-rate mortgages. Of course, no one can precisely predict what interest rates will do in the next few months or years. But by calculating different "what ifs" you can get an idea whether or not an ARM might make sense for you. If you need additional help making your decision, talk to your credit union mortgage lender.