Pros and Cons of Adjustable Rate Loans

There is considerable debate over the merits of an adjustable rate (AR) loan compared to a fixed-rate loan when it comes to saving money on them. This is because each type of loan can be a mixed bag. Often, adjustable rate loans begin with a low initial interest rate in an adjustment period, followed by variability according to an agreed index. However, a lower rate does not always mean “better loan.” This floating-rate arrangement can work for some persons, but this depends on the prevailing context and the borrower.  Careful analysis of the pros and cons of adjustable rate loans is essential.

== Pros of Adjustable Rate Loans ==

♦ Lower rates

Adjustable rate loans usually have lower rates than fixed ones. The reason for this is that fixed rates already account for fluctuations over the repayment period. Think of a fixed rate as an average. With averages, there are bound to be rates below the average (as well as above). The initial interest rate on an adjustable rate loan can easily be below the average that the fixed-rate loan represents. That the low rate is fixed for a specified period makes this type of loan appear more attractive.

♦ Safety nets

This type of loan normally utilizes limitations on charges. These have different consequences, and include mortgage payment caps, lifetime caps and periodic caps. Although there would be some variability past the adjustment period, the borrower would already know the limits, since this is disclosed in the mortgage agreement.

♦ Reduced carrying cost of rental properties

With a low initial interest rate, the adjustable rate home loan reduces the carrying cost of a rental property or one that is going to be held for the short term. This is because the low rate in the adjustment period creates a lower payment, which is an expense. For those planning to flip a house using a mortgage, or sell within the adjustment period, the AR loan can be beneficial.

♦ Other benefits

Refinancing options might be available with AR loans. In some cases, it is possible to refinance to a fixed-rate mortgage later on. This is a good option for those who flip houses or plan to sell the home within a few years. In addition to this, the concept of adjustable rate loans ensures that borrowers can access loans even in periods of rate fluctuations, when lenders consider it risky to offer fixed-rate loans.

== Cons of adjustable rate loans ==

♦ Lower rates do not last forever

All good things must come to an end. Such is the case with the initial interest rate on this loan. Invariably, the adjustment period must end, leaving the rate to increase or decrease. If an increase is likely, then increased mortgage payments are the natural result.

♦ Uncertainty

The future is uncertain, and the variability of the interest rate can render prepayment of the loan risky and untenable. Paying off the balance when interest rates are high can be a more expensive option. The uncertainty of the adjustable rate loan also suggests that borrowers must be financially prepared to face interest rate increases. If they were expecting extra income by that time and it did not materialize, then financial difficulties can result.

♦ Negative amortization

A negative amortization payment suggests that the mortgage balance is not being reduced. In fact, it is likely being increased. In the rare case that an adjustable rate loan has a cap of the mortgage payment in terms of the dollar amount, this can leave the borrower susceptible to negative amortization. This happens if the interest rate increases such that the mortgage payment exceeds the payment cap. What happens then is that whenever the mortgage payment is made, the mortgage balance increases, as opposed to decreasing (the meaning of “amortization”).

♦ Prepayment penalties

Some adjustable rate loans have prepayment penalties. Such penalties are designed to preserve the profitability of the loan to the lender. They do this by preventing the borrower from taking advantage of low interest rates by attempting to settle the loan with those conditions. Prepayment penalties are clearly not in the interest of borrowers.

Weighing the pros and the cons shows that it is not a given that adjustable rate loans are better or worse. How well they work depends on how well a borrower can maximize the benefits and reduce the inherent risks and disadvantages. Some AR loans are hybrid – a mixture of fixed-rate and adjustable components. Such loans attempt to get the best of both worlds, and might be the option for those who want the benefits of the adjustable rate loan without the burden.