Adjustable Rate Mortgage

Introduction

An adjustable Rate Mortgage, or ARM, is a mortgage loan that allows the Interest rate and Monthly Payment to move up and down as market interest rates fluctuate. Initially, the loan is set at a fixed rate for a period during which the Borrower's rate doesn't change. This is followed by a much longer period during which the rate changes at preset intervals. During these initial periods, rate charges are generally lower than those on comparable Fixed Rate Mortgages. Lenders offer low rates at first because the borrower knows that he or she will have to assume the risk of higher rates in the future.

Initial Fixed Rate Period

The initial fixed rate periods are sometimes flexible. They can be as short as a month or as long as 10 years. One year ARMs used to be the most popular adjustable loan and were the benchmark, but had their first adjustment after one year. The standard has recently become the 5/1 ARM, which has an initial fixed rate period that lasts five years; the rate is adjusted annually thereafter. This type of mortgage, which is called a hybrid, mixes a lengthy fixed period with an even lengthier adjustable period. Other popular hybrids are the 3/1, the 7/1, and the 10/1.

Cap Limit

ARMs come with caps which protect borrowers from extreme changes. These caps limit the amount by which ARM rates and payments can adjust. There are a few different forms of caps. The most common are periodic rate cap, lifetime cap, and payment cap. Periodic rate cap limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from rising more than a certain number of percentage Points in any given year. Lifetime cap limits how much the Interest Rate can rise over the life of the loan. Payment cap limits the amount of the monthly payment can rise over the life of the loan in dollars, rather how much the rate can change in percentage points. Payment cap is only offered on some ARMs.

Interest Only

Interest only ARMs were marketed around the turn of the 21st century to middle class borrowers. These loans require the borrower to pay only the interest for a specific period, often 10 years. Then, it adjusts to the going interest rate, as tracked by a specific Index. The loan, then, amortizes at an accelerated rate. During the interest-only period, the borrower can choose to pay some of the Principal. Clearly, this type of interest-only mortgage provides flexibility in the size of the monthly payments making it a good match for people with fluctuating monthly incomes like a salesperson working on Commission.

Convertible ARMs

The great thing about ARMs is that some of them come with a feature that allows the borrower to convert their loans to fixed rate mortgages for a fee. To keep their payments low, others allow borrowers to make interest-only payments for a portion of their loan terms. Unfortunately, no matter the exact terms, most ARMs are more difficult to understand than fixed rate loans. The best advice is to keep your financial options open and ask a mortgage Lender if the ARM is convertible to a Fixed Rate Mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. Assuming a mortgage is desirable if interest rates are high.

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