Adjustable rate mortgage (ARM) basics

Adjustable rate mortgage basics

An adjustable mortgage (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 stays the same during the entire tenure of the loan. With an adjustable rate mortgage, the interest rate changes periodically over a period of time. The change of interest rate usually occurs in relation to an index, and your payments may vary as and when this index goes up or down. Banks and credit companies usually charge a lower initial interest rate for ARMs in comparison to fixed rate mortgages. The starting interest rate period ensures that the monthly mortgage payment amounts are lower for an ARM, rather than a fixed rate mortgages for the same amount of loan. An ARM could also be more affordable than a fixed-rate mortgage over a longer period of time

Adjustable rate mortgages advantages

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

If you can avail a significantly lowered interest rate with an ARM as compared to a fixed rate mortgage, and you do not anticipate a significant increase the economic index over the life of the mortgage, going in for ARM proves to be more beneficial.

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

If you expect a substantial increase in your monthly income over a period of time, and you may be planning to buy a larger home later on, availing long term APR might provide ample opportunities for a lowered interest rates, since the current market trend suggest a gradual decrease in lending rates and the indices keep on fluctuating in the borrower favor.

ARM disadvantages    

The two biggest disadvantages to signing an ARM can be:

You are exposed to the risk of the index going up and increasing your interest rate if the market fluctuates against your requirements. So there are a certain tolerance levels or risk associated with ARMs. If you plan to benefit by availing advantages of a discounted ARM, you might have to undergo a significant increase in your mortgage payment as soon as the second year of your mortgage.

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

More about payment limits or caps

You can make sure that your adjustable rate mortgage payments do not grow beyond your paying limits is to make sure your mortgage is associated with a maximum limit or a payment cap. A payment cap typically helps to control the limit of the repayment amount you are expected to pay at the end of each month. The problem is that majority of the mortgage deals do not provide an upper limit or cap subjected to the interest rates. If this happens, it can lead to negative amortization since the monthly outstanding dues cannot cover the net payable monthly interest for the mortgage.

Even if you do get a payment cap and an interest cap simultaneously, and you are able to limit the maximum amount payable each month and the maximum interest rate applicable for the same amount, you may still end up with issues. Interest caps will help to keep your interest rates down regardless of index highs, but the terms associated with the mortgage note will facilitate the mortgage refinance company to pass on the increases forward on to the next adjustment period. 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 you the remaining 1% at the end of the second, even if the indexes go lower down for that year.