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Adjustable Rate Mortgages (ARMs)

Mortgages are classified as fixed rate and adjustable rate mortgage based on whether the terms of the payment are constant or variable. In this article, you will understand the features, advantages and disadvantages of adjustable rate mortgage.

In contrast to fixed rate mortgage where the interest rate and monthly payments are fixed during the term of the mortgage, in adjustable rate mortgage (ARM) the interest rate and monthly payments changes at established intervals based on fluctuations in a pre-established index. The ARM interest rate is linked to an economic index and adjusted at specific intervals in line with the changes in the Index. The index is the baseline rate that lenders use to measure interest rate changes. The most common index is 6-month Treasury Bill or 6-month CD. The rate of interest charged on the mortgage is the index rate plus a margin for the lender. The period between one rate and payment change to next is called adjustment period. This period varies from 3 months to 5 years. However, the typical adjustment period is 6 months or 1 year.

The ARM also includes some provisions to protect you against the extreme adverse movement of interest rates. The interest rate cap is a feature that protects you from extreme increases in interest rates and monthly payments. There are two types of interest rate caps - periodic caps and overall caps. The periodic cap limits the interest rate increase from one adjustment period to the next, whereas overall cap limits the interest rate increase over the life of the loan. Another feature used to protect borrowers in ARM mortgage is payment cap. Payment cap limits the monthly payment increase from one adjustment period to another. Generally, ARMs with payment caps often do not have periodic interest rate caps.

The lender is protected from the adverse interest rate movement through the provision of carryovers. If the interest on mortgage is down even though the index went up due to interest rate cap, the amount of the increase can be carried over to the next adjustment period.

The advantage of an ARM is its lower initial interest rate, which allows borrowers to qualify for higher loan amounts. Another advantage is that the borrower is benefited from the interest rate adjustment if the index rate decreases. The disadvantages of ARMs are the unknown fluctuations in the monthly payments from one established period to the next. However, with caps in place the borrower knows the worst-case scenario. Another disadvantage is that if one is willing to convert to a fixed rate then the conversion rate may be slightly higher than the market rate.

When to Choose an Adjustable Rate Mortgage?

Depending upon one's risk preferences, financial requirements, credit standing and stage in life cycle, one can decide whether to go for fixed rate mortgage or ARM. Since the size of the monthly payments varies with the interest rate, you are hedging yourself against the market forces. So if the market interest rates are low, you are enjoying the low interest rates and vice versa. The other reasons for choosing the ARM are:
  • When you feel that the interest rates are all time high and are likely to drop in future, go for ARM. You will save money as soon as the interest rates drop.
  • If you have a cushion of extra income or wealth and can afford the monthly payments even if interest rate increase, you can take advantage of ARM, which are generally cheaper than fixed rate mortgages.
  • If you are expecting an income increase in future, which can cover any increased payments due to interest rate increase, you can take advantage of comparative low cost of ARM.
  • When you intend to stay in the home for few years only the ARM is better for you.

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