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Thinking of getting an adjustable rate mortgage? Suze Orman says you need to ask yourself these questions first

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This is advice to follow.

Key points

  • You could get a lower initial interest rate on a variable rate mortgage.
  • But these loan products are risky, so borrowers should proceed with caution.
  • Be sure to ask yourself if you can afford higher rates down the line.

With mortgage rates on the rise this year, many homebuyers are trying to find ways to reduce their borrowing costs. And one of the ways to do that – at least initially – is to opt for a adjustable rate mortgageor ARM, rather than sticking with a fixed rate loan.

With an adjustable rate mortgage, you lock in an interest rate for a pre-set period of time. But once that time has elapsed, the interest rate on your loan may change depending on market conditions.

Now that means the interest rate on your mortgage has the potential to drop, leading to lower monthly payments. But it could also go up. And so if you are considering taking out an adjustable rate mortgage, it is important to understand the risks involved.

In fact, the financial expert Suze Orman urges borrowers to proceed with caution when purchasing an ARM. And she insists that if you want to go down this path, you have to go through these key questions first.

1. What is the maximum increase at the first adjustment?

The advantage of getting a variable rate mortgage is that you are guaranteed a period during which the interest rate on your loan will remain the same. With a 5/1 ARM, for example, you can lock in an initial interest rate on a mortgage for a period of five years. From there, your rate has the potential to increase once a year. (This is what the “5” and “1” represent respectively.)

But once the interest rate on your loan has the potential to go up, it can go up a lot. Orman warns that your mortgage rate could increase by up to 2 percentage points during its first adjustment.

As such, if you are going to remove an ARM, use a mortgage calculator to see what your new monthly payments will look like once this higher interest rate takes effect. If you can’t afford the amount you see, that’s a sign that an adjustable rate mortgage is a bad idea.

2. What is the maximum increase the following year and the year after?

When you take out an adjustable rate mortgage, you don’t just face a one-time increase. On the contrary, the interest rate of your loan has the potential to adjust once a year. So it’s important to also use these numbers in a mortgage calculator to see what kind of payments you might receive.

Keep in mind that with an ARM there is usually a cap on the amount of interest you can be charged. But Orman warns that the cap could be as high as 6 percentage points above your loan’s starting rate. This means that if you sign an ARM at 5%, you could end up with a rate as high as 11% down the line.

3. What if I can’t refinance out of an ARM?

Some people sign an MRA with the intention of refinance once the interest rate on their loan begins to rise. But you shouldn’t assume this will be an option for you.

If mortgage rates are up across the board at that time, refinancing may not make financial sense. And if your credit score happens to take a hit, you may not be able to get a more competitive rate on a mortgage. You will need a backup plan in case refinancing is not an option (or a good option).

There’s no guarantee that taking out an adjustable rate mortgage will work against you, but it can. It pays to take Orman’s advice and answer these key questions before moving forward with one.