Adjustable rate mortgage (ARM) basics

Adjustable rate mortgage basics

An adjustable ratemortgage (ARM) is quite different from a fixed rate mortgage in many ways.The major difference in a fixed-rate mortgage is that the interest rate staysthe same during the entire tenure of the loan. With an adjustable ratemortgage, the interest rate changes periodically over a period of time. Thechange of interest rate usually occurs in relation to an index, and yourpayments may vary as and when this index goes up or down. Banks and creditcompanies usually charge a lower initial interest rate for ARMs in comparisonto fixed rate mortgages. The starting interest rate period ensures that themonthly mortgage payment amounts are lower for an ARM, rather than a fixed rate mortgagesfor the same amount of loan. An ARM could also be more affordable than afixed-rate mortgage over a longer period of time

Adjustable rate mortgages advantages

You may wonder why anybody would consider anARM as a good idea. It actually depends upon your specific financialcircumstances and loan paying options. Some examples of when an adjustable ratemortgage may make sense for you are:

-If you can avail a significantly loweredinterest rate with an ARM as compared to a fixed rate mortgage, and you don’tanticipate a significant increase the economic index over the life of themortgage, going in for ARM proves to be more beneficial.

-If you plan to stay or maintain your homefor a few years at least, allowing substantial time for any drastic interestrate/index increase, the ARM can help you with an attractive interest rate.

-If you expect a substantial increase in yourmonthly income over a period of time, and you may be planning to buy a largerhome later on, availing long term APR might provide ample opportunities for alowered interest rates, since the current market trend suggest a gradualdecrease in lending rates and the indices keep on fluctuating in the borrower’sfavor.

ARM disadvantages

The two biggest disadvantages to signing anARM can be

-You are exposed to the risk of the indexgoing up and increasing your interest rate if the market fluctuates againstyour requirements. So there’s a certain tolerance level or risk associated withARMs. If you plan to benefit by availing advantages of a discounted ARM, youmight have to undergo a significant increase in your mortgage payment as soonas the second year of your mortgage.

-Negative amortization can result into youowing more on your home than your expected amount originally worked out.Amortization is the process by which your loan amount gets reduced as you keepon paying your payments or monthly dues, however, if you realize that your ARMis increasing more quickly than your ability to make your mortgage payments,the mortgage company is likely to apply any partial payments to your interestamount first. If the partial payments “paid” by you are not sufficient to coverthe full interest amount due for a particular month, the same can be added intothe principal amount of your loan. This, in effect, increases your principalbalance.

More about payment limits or caps

You can make sure that your adjustable ratemortgage payments do not grow beyond your paying limits is to make sure yourmortgage is associated with a maximum limit or a payment cap. A payment captypically helps to control the limit of the repayment amount you are expectedto pay at the end of each month. The problem is that majority of the mortgagedeals do not provide an upper limit or cap subjected to the interest rates. Ifthis happens, it can lead to negative amortization since the monthlyoutstanding dues cannot cover the net payable monthly interest for themortgage.

Even if you do get a payment cap and aninterest cap simultaneously, and you are able to limit the maximum amountpayable each month and the maximum interest rate applicable for the sameamount, you may still end up with issues. Interest caps will help to keep yourinterest rates down regardless of index highs, but the terms associated withthe mortgage note will facilitate the mortgagerefinance company to pass on the increases forward on to the next adjustmentperiod. It means if at the end of first year if the interest rates go up by 2%and you have an interest rate cap of 1%, the mortgage company can charge youthe remaining 1% at the end of the second, even if the indexes go lower downfor that year.