Adjustable Rate Loan Versus Fixed Rate: Which One Is For Me?

All you have to do is look at a California loan rate tool, which is offered on most websites about mortgages and real estate, and you will see that the appeal of an adjustable rate mortgage is rearing its ugly head once again. It is no secret that the irresponsible entering of these types of loans played a significant part in the housing bubble and following collapse that we have been experiencing over the course of the last few years. However, these loans are there for a reason, and can provide an excellent service to someone who understands exactly what they are getting themselves into.

For those of you who do not exactly understand what an adjustable rate mortgage is, it is basically a loan that has an interest rate that can adjust with the market. When you see a term such as a 5/1 ARM, all that means is that this loan carries a fixed interest rate for five years, and then adjusts every year after. This can be an excellent thing for people, should the interest rate fall over the next five years. It also, however, means that the interest rate can increase for people, causing their payment to go to a level that they can no longer afford, which is what we saw when everything started to go sour a few years ago. So, the big question becomes how can we decide whether or not we are better off with a fixed rate mortgage at a little bit higher rate, or an adjustable rate mortgage that is fixed at a lower interest rate for some period of time, and then is at the mercy of the market.

First of all, there are a few questions that you should ask yourself right off the bat that can make the decision easier for you:

1) Am I looking to stay in the house longer than the fixed period of time the adjustable rate mortgage comes with?

2) Am I only interested in this loan at the interest rate offered by the adjustable rate mortgage during the fixed period of time?

3) Is the house I want out of reach with a traditional fixed loan, but within reach with the interest rate offered during the fixed period of time offered by the adjustable rate mortgage?

If you answered yes to any of these questions, I would seriously consider not entering into a loan that has an adjustable interest rate. The reason why is because living in the house longer than the fixed period of time will leave you vulnerable to the unpredictable actions of the market. Any responsible financial advisor or consultant would not advise you to do something like this, unless they were sure that you were financially prepared for any swing the market might take. Buying within the price a fixed interest rate allows is definitely the more safe and financially sound decision.

But wait. There has to be some financially sound reason to enter into an adjustable rate mortgage. There is, but it has nothing to do with where the market might end up in the future. That type of speculation is irresponsible. A good reason to enter into this type of loan would be after you have already assumed a plan on counterbalancing the potential change in the loan after the period of time when the loan is fixed. For instance, are you looking to rent this property? If so, then you have the ability to enter into a contract with a renter that adjusts based on the current market condition, just like your loan. Maybe you absorb some of the cost, maybe all of it. The point is that you have been in the free and clear for, let's say, five years, enjoying the low interest rate that came with your loan, and having someone else pay for your home. When the time comes, if the interest rate becomes more than you are willing to pay, there are a number of options, such as refinancing or selling, which leads me to my next point.

There are plenty of tax incentives available to people looking to sell their property. In fact, did you know that there are zero taxes on capital gains made from selling your property, had you lived in that house for two of the last five years? All of a sudden, we found a great way to take advantage of the low, temporary fixed rates, and then sell off our home, receiving 100% of the equity it has accrued over the course of four or five years. This is just one of many strategies available that take advantage of an adjustable rate mortgage. All of them, however, require careful planing and follow through, in order to avoid being hit by the possible increase in payments.

Anthony Flores is a real estate agent and investment advisor in Corona, Ca.  He specialized in the homes for sale in Riverside, and offers more strategic articles and commentary on his blog, Southern California Home Source