Adjustable rate mortgages, rather than fixed-rate mortgages, may be confusing for many homebuyers who are not familiar with them. It is always a good idea for a homebuyer to have all the information needed to make an informed decision.
The adjustable rate mortgage (ARM) is popular with home buyers looking for a lower interest rate for the first few years of ownership. Why are they popular? Simply put, they are structured to help people have lower payments for the initial period of the loan (the fixed-rate portion of the loan).
How an ARM Works
The overwhelming majority of adjustable rate mortgages are 30-year mortgages. For the "ARM" portion of the mortgage, you pay a fixed interest rate. This initial period is usually 3, 5 or 7 years, but can vary based on the lender.
For the first 3, 5 or 7 years (or whatever the term is) you will have a defined interest rate and you will know what your payments are each month. This is the key principle of the ARM loan -- a lower interest rate for the initial period (lower than what a 30-year fixed rate mortgage would be). This helps many first-time home buyers purchase a home in the first place.
When the ARM Adjusts
After the ARM period ends, the loan becomes an adjustable rate. A formula (defined by your lender) will then be used to determine your interest rate for that year. It will be based on the prime rate at the time of adjustment, which you never know in advance.
Refinancing Prior to Adjustment
Home owners concerned with rising interest rates can refinance their loan prior to the ARM period expiring. This converts the adjustable rate mortgage into a fixed-rate mortgage.
Other ARM Considerations
When considering an adjustable rate mortgage, you will want to pay careful attention to the fixed-rate portion of the loan. Also find out what, if any, caps there are on the adjustable rate portion of the loan. Ask your loan officer those questions so you can make an educated decision.
Some home buyers like ARM loans because they are expecting an increase in income over the next 3 to 5 years so they know they can afford a higher interest rate at that time, and they are comfortable taking out this type of loan. Other home buyers like ARM loans because they do not intend to live in the home beyond the period of the fixed-rate portion of the loan, so they benefit from the lower interest rates up front without the uncertainty of the adjustable period.
As you consider adjustable rate mortgages and fixed rate mortgages, you should ask your loan officer to show you amortization schedules. These schedules show how much your payments will be and how much of the payment goes towards interest and how much toward the loan's principle.
Every lender has different nuances with their fixed rate mortgages. Make sure there are no pre-payment penalties -- if there are, you need to factor that into your overall thinking about which type of loan is better for you.
An informed consumer is a smart consumer. Doing your homework in advance will help you understand the mortgages and thus make the right financial decision.
* Copyright 2006, Brandon Cornett. You may republish this article if you keep the byline and author's note, and also leave the hyperlinks active.
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