How To Compare Adjustable Rate
With the popularity of adjustable (variable) rate mortgages continuing to grow in major markets like the GTA, the need for accurate comparison of these products becomes increasingly important. While traditional closed term mortgages are very easy to compare, adjustable rate mortgages (ARM’s) take a great deal of understanding to effectively evaluate. Where selecting closed term mortgage from one or two institutions offering the same rate would likely only mean a slight variation in the privileges provided, the options and interest calculations on adjustable rate mortgages can literally mean the difference of being financially savvy or being conned.
The problem with evaluating adjustable rate mortgages really stems from two things. First, comparing the effective prime discount (or cost of borrowing) requires a relatively complex (for the average consumer) financial calculation for many of the product offerings. Second, to compare the privileges and features and the resulting impact, you have to understand what they all mean, as well as know the right questions to ask.
Understanding that the majority of consumers do not have the knowledge or ability to do the two things I have just mentioned, many institutions are now re-capturing the margins that they once received from naïve consumers on closed term products by putting them into adjustable rate mortgages that compromise rate, privileges, or both. Before you sign for the biggest loan that you will likely ever have in your life, here are some things that you should definitely know in advance (and as always get them in writing):
1. Don’t be fooled by the low introductory teaser rates or prime discounts:
Take the time to determine your average cost of borrowing until the mortgage becomes open (or renews). The low introductory teaser rates currently offered may actually make it beneficial for you to switch institutions every few years. To effectively compare the rates offered on ARMs, you need to determine the average cost of borrowing for the period until the mortgage becomes fully open (or renews). To do this you need to do a weighted average calculation that will give you the effective cost of borrowing. A weighted average calculation can be done by: 1) multiplying the introductory rate by the number of months it is in effect, 2) multiplying the rate after the introductory period by the number of months until the mortgage becomes open (or renews), and 3) take the total from 1 and 2 and then divide this number by the total number of months in 1 and 2.
2. Understand the conversion options and the rate discounts:
Many people sell clients on the idea that you can convert an adjustable rate mortgage to a closed term mortgage without any penalty at any time – so what??? Know exactly what the rate discount will be if you convert. If it costs you three months interest to switch to another financial institution they have got you trapped when you go to negotiate your closed term rate. Make sure that when you convert to a closed term you will get a good discount on the closed rate otherwise be prepared to stay variable until it becomes open or renews.
3. Know how rate changes will affect your payments:
Some adjustable rate mortgages have payments that adjust as prime moves while others do not. When prime goes up and your payment stays the same then the portion of your mortgage payment that goes towards principal is decreased. This means that your amortization period is also extended. Do you really want a mortgage that takes 35 years to pay off? Also, if the payment adjusts regularly – will this keep you awake at night?
Please don’t misunderstand my caution; I think adjustable rate mortgages are great products that have finally received the attention they deserve. ARMs are to mortgages what stocks are to investing – that is to say that staying with them should make you better off financially in the long run. In a time when rates are expected to decline they give you a lot of flexibility, but truthfully they are a product that many of the financially savvy have been using for years. While the ups and downs of their face interest rates are not for everybody, those who possess the financial and psychological ability to endure generally won’t consider anything else. With pre-payment privileges and rates that are amongst the most competitive in the market, this is one risk that has a tendency to pay off.