Once you have established how much you will pay on the best fixed rate loan you can get, start getting quotes on adjustable rate loans. The first rule is to ignore the start rate unless it is the only way you can qualify. If this is the case, you cannot compare the adjustable to the fixed rate loan because you cannot qualify for the fixed rate loan at the amount that you are trying to borrow. If you are still determined to borrow this amount, ask the following questions.
• How much will the rate be after the start rate ends?
• What will be the amount of your monthly payment once that happens?
Do not settle for the answer that it depends on the rate at the time of adjustment. You want to know the rate and payment based on rates today. You then want to know the adjustment period and how it will affect your payment if it adjusts to the maximum allowed during each period. Follow the adjustment up to the cap. In other words, if the loan over the years adjusts to the maximum rate, what will be the interest rate and the monthly payment? Will this payment amortize over the term or will there be a balloon payment due?
In order to weigh the risk of the interest rate going all the way up to the cap, you have to know which index will be used. If the lender is using a lagging indicator, such as the Cost of Funds Index, there is less chance that it will rise to the cap. Even if it does, it will take much longer to get there than a leading indicator. This at least gives you more time to increase your income or eliminate other debts.
Once you have all this information, go back to your spending analysis. Could you afford to make the highest possible payment by cutting out unnecessary spending? If the answer is no, you are going to depend on interest rates not going up to the maximum, your income increasing, or paying off current debts to free up some cash. You may decide to take the risk. Many, if not most, borrowers do not even know the risk. If there is no problem with qualifying, you still make the same analysis. You are, of course, in a better situation. You are now trying to determine which loan will cost you the least without considering whether you can get the loan. Ignoring the start rate, you compare break-even dates for each type of adjustable loan.
For loans that are fixed for three, five, seven, or even ten years and then adjust, you have to compare the cost of each. You compare the rates, fees, and any prepayment penalties for these loans based on how long you intend to keep the loan.
Once you have found the best adjustable rate loan for your time period, compare it to the fixed rate loan. The time period is the critical part. Using the worst-case scenario, the adjustable rate loan will never be better than the fixed rate loan over the full term. The general rule is that the adjustable rate loan will almost always be better if paid off within five years, depending on a possible prepayment penalty. Extending it a few more years gets into uncertainty.
There are two variables that have to be considered. Whether rates will rise, fall, or stay stable is the first major consideration. If you believe that the economy is entering a period of rapidly increasing interest rates, the fixed rate loan is the obvious choice. If you believe interest rates may rise, but not too much or too fast, an adjustable loan, especially one using a lagging indicator, may be acceptable. Falling rates favor the adjustable loan since it is cheaper for the first few years and you will probably refinance as rates go down.
The second variable is how long you intend to keep the loan. Generally, shorter periods favor the adjustable loan. You can see that there are decisions to make based upon future occurrences. Since the future cannot be predicted with absolute accuracy, you cannot be absolutely sure that the loan you get will turn out to be the least expensive over the years. Preparing yourself to make the decision based on solid information, rather than advertising and lures of low payments, will most likely make your decision the correct one.