How Do Adjustable Rate Mortgages Work

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Adjustable Rate Mortgage Rates

How Do Adjustable Rate Mortgages Work

How do adjustable rate mortgages work? An adjustable rate mortgage (ARM) also known as a Floating Rate or Variable Rate Mortgage is a mortgage loan with a fluctuating (rather than fixed) interest rate. Adjustable rate mortgages are subject to periodic interest rate adjustments based on an index (an outside indicator of the prevailing interest rates in the market, such as interest rates on U.S. Treasury bills or the average national mortgage rate). These adjustments come at pre-determined regular intervals and may involve raising or lowering of the loan's interest rate, depending on the changes in the market.



More On Adjustable Rate Mortgages Explained

Adjustable rate mortgages ensure a steady margin for mortgage lenders, since lenders' cost of funding usually depends on the index. With an Adjustable Rate Mortgage, some of the risk of unpredictable interest rates is transferred from the lender to the borrower. If interest rates rise, the borrower pays more; if interest rates fall, the borrower pays less. Thus, Adjustable Rate Mortgages have potential benefits for borrowers also. However, borrowers should be careful not to take on a mortgage amount that they might struggle to pay back should interest rates rise.

Adjustable rate mortgages are similar to Graduated Payment Mortgages in that payments fluctuate, but Graduated Payment Mortgages have a fixed interest rate, while Adjustable Rate Mortgages do not. Other types of mortgages include fixed rate home loans, interest only mortgages, balloon payment loans, a reverse mortgage and optional-payment ARMs.

What Are the Benefits of Adjustable Rate Mortgages?

The interest rate on adjustable rate mortgages changes according to an economic index; thus, if the index lowers, the interest rate on the loan lowers with it. Rates on fixed rate home loans on the other hand, remain the same regardless of the index.

Furthermore, adjustable rate mortgages usually offer lower initial interest rates than fixed rate mortgages. This lower rate results in lower payments, which can allow borrowers to qualify for a larger loan amount. Also, homebuyers who plan to re-sell the home in a few years need not worry overmuch about rising interest rates, thus making the initial low interest rates of an ARM especially attractive. Finally, borrowers who expect their income to rise might choose an ARM for the initial low interest, counting on their higher income to cover the higher payments that will come when the interest rate rises.

Finally, ARM loans, like other loan types, usually permit borrowers to make early payments without penalty (resulting in faster reduction of the principal, or capital, and lowering the total amount of interest paid). Adjustable Rate Mortgages can also sometimes be refinanced when interest rates drop significantly, which also allows early payoff of the entire loan amount. Many homeowners choose to refinance their mortgage once the adjustable rate period has expired.

Risks of Adjustable Rate Mortgages

Some borrowers choose an ARM loan based on the initial low interest rate, not considering whether they will be able to make the payments when the interest rates rise. Furthermore, some consumers borrow a greater amount than they would have been able to with a fixed rate mortgage, only to discover that they borrowed more than they can handle. In extreme cases, bad credit lenders offer what are characterized as "predatory loans," loans with hidden costs or poor terms that offer no protection to borrowers should interest rates rise sharply.

Borrowers can shield themselves against rising interest rates and payment hikes in numerous ways, the most important of which is to choose a credible mortgage lender offering reasonable terms both initially and in the future. Also, though borrowers cannot choose the index applied by their lender, they can choose a lender and loan based on the index used. ARM borrowers should look for loans that are linked to an index with a relatively stable (unchanging) rate history.

Finally, borrowers can protect themselves against interest rate increases by choosing loan terms with: a) an initial fixed-rate period (which allows the borrower to increase his/her income before rates begin to rise; b) a periodic interest rate cap (which limits the amount the borrower's interest rate can increase from one adjustment period to the next); and/or c) and overall interest rate cap (which limits how much the interest rate can increase over the lifetime of the loan).

Optional-Payment ("Option") Adjustable Rate Mortgage

An "Option" ARM refers to a loan structured in such a way that the borrower gets to choose between several different payment types each month. Thus, each month the borrower decides whether to make a minimum or limited payment (usually less than the amount of interest due that month, resulting in negative amortization, or an increased principal); an interest-only payment (with the option to pay more than the interest and thus reduce the principal if possible); or a traditional full payment (usually based on a set loan term of 15 or 30 years, and covering all of the month's interest and part of the principal). This allows borrowers to have greater flexibility and freedom when making payments on the loan. In addition, Option ARMs usually feature very low initial interest rates.

Who Should Choose an Optional-Payment Adjustable Rate Mortgage?

Optional-Payment ARMs are ideal for consumers with fluctuating income. For instance, people who have seasonal jobs, work on commission, or receive periodic bonuses can benefit greatly from an optional-payment plan. Such people can make minimum or interest-only payments during low-income periods and can switch to full payments when they have more money.

Also, Optional-Payment ARMs might be a good idea for borrowers who expect their income to increase in the future and thus wish to operate on a "buy now, pay later" plan. These people can make minimal payments each month while their income remains modest, then increase the payment amounts as their income increases.

Optional-Payment ARMs allow these types of borrowers more flexibility in paying back their California home loan, and enables them to avoid the penalty fees and foreclosure risks that accompany fixed rate loan.

Optional-Payment Adjustable Rate Mortgage Rates

Optional-Payment ARMs are not recommended for borrowers who receive steady (unchanging) income. The amount such borrowers can pay each month is unlikely to change, and the temptation to pay minimum or interest-only payments (resulting in negative amortization) is likely to increase the amount of time it takes to pay off the loan and the total amount of interest paid.

Optional-Payment ARMs are also not recommended for borrowers who do not understand the rather complicated terms of optional-payment plans. Optional-Payment ARMs are very attractive to consumers because they offer flexible payments and low initial rates. Thus, consumers can borrow a larger amount while appearing to make lower payments. However, the initial low interest rates usually only apply for a short time (sometimes only for the first month!), and the lowest monthly payment options result in a principal amount that only gets bigger with each payment. Finally, most optional-payment ARMs come with a built-in recalculation period (usually after five years), which can potentially change the amount of the principal, the time span for repaying the loan, and the options available for monthly payments. For this reason, only people who fully understand the pros and cons of Optional-Payment ARMs and who understand the value of making the full monthly payment even with "cheaper" options available should consider borrowing on optional-payment terms.

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