What You Need To Know About Adjustable Rate Mortgages
What is an adjustable rate mortgage? How do they work? How do you know if they're right for you?
An ARM is a mortgage with an interest rate that changes, periodically, during the life of the loan, according to a specified index and time schedule.
Since interest rates for fixed-rate financing remain the same for the life of the loan, a lender may lose money if, for example, inflation increases interest rates. As a result, the adjustable rate mortgage was created to balance the risks from changing interest rates between lender and borrower.
ARM's are popular because of the lower initial interest rate, as compared to an often-higher interest rate for fixed rate financing. The lower interest rate makes it easier to qualify for a loan because less income is needed. Also, if you only expect to live in your house for three to five years, an ARM may be the best choice because initial interest rates are lower.
On the other hand, an ARM does not allow the borrower to anticipate precisely what mortgage costs will be over the life of the loan. At each adjustment period, your ARM interest rate and monthly payment may change. As a result, it may be more difficult to plan your finances.
ARM's typically offer an initial rate of interest that is below the rate for fixed-rate mortgages.
When the initial interest rate period ends, interest is then determined on the basis of an index. Indexes that are often used include the U.S. Treasury Constant Maturity Rates (CMT's), the Cost of Funds Index (COFI), or the one-year Treasury Bill Index.
Make sure you consider whether you can afford payments in the future, when the discount expires and the adjustment is made to the rate. Although the rate change could occur every month, it is more likely that it will change every several months, or once a year. A payment cap may also be included in an ARM, which limits your monthly payment increase at the time of each adjustment period, usually to a percentage of the previous payment. Many ARM's with payment caps do not have periodic interest rate caps.