An ARM, which stands for "adjustable rate mortgage," is a type of mortgage where the interest rate on the loan changes on a set schedule based on an index. Most of the time, the following are used to figure out interest rates:
Treasury securities with a constant maturity of one year (CMT)
Cost of Funds Index (li): (COFI)
London Interbank Offered Rate (LIBOR)
Costs of funds for a lending institution.
So, your mortgage payment will change, either going up or down, to keep a steady profit margin for the bank.
Adjustable rate mortgages can seem like a great idea to many people who are looking for mortgages. However, there are many pros and cons to an adjustable rate mortgage that need to be weighed over the short and long term to decide if an adjustable rate mortgage is right for you or not.
The pros of a mortgage with a changing interest rate
On paper, the first interest rate on a loan with an adjustable rate looks great. Most of the time, the rate on an adjustable rate mortgage is much lower than the rate on a fixed rate mortgage. This means that the payment is also lower. As a borrower, this lower interest rate can also mean that they can get a bigger loan if the lender is willing to judge their ability to pay based on the first monthly payment amount. It's important to look into interest rates and see where they are now compared to where they were six to twelve months ago.
People who only plan to live in a house for three to five years should get a mortgage with a rate that changes over time. In this case, it would be smart to use the lower interest rate that comes with an adjustable rate mortgage. It means that over the next three to five years, you will "pay less" for the home you will be living in and gain more equity in your home.
The bad things about a mortgage with an adjustable rate
The biggest problem with an adjustable-rate mortgage is that the interest rate will go up, which means your monthly mortgage payments will go up as well. You have to decide if the risk is worth taking. If you expect to get a raise from your job in the next year, you might be able to handle a rise in your mortgage payments.
Some of the adjustable-rate mortgages that banks and credit unions offer come with a prepayment penalty if you pay off the loan early. Having this prepayment penalty could lead to a lot of trouble. Having a prepayment penalty in your mortgage contract is never a good idea, because you never know what will happen in the future.
You must also think about how much you can be paid. A payment cap sounds great: your mortgage payment can't be more than "x" dollars, but that doesn't mean that the amount of interest you pay is capped. If the interest rate goes up so much that you can't make your maximum payment, the lender adds the interest to your mortgage debt. Then you have to pay interest on the interest you paid. This can mean that you pay a lot more for your home than you did when you bought it. This is called negative amortisation. Many lenders have a limit on how much negative amortisation you can have. If you reach that limit, your payment cap goes away and your monthly mortgage payments are changed to start paying off the negative amortisation debt.
Things that could go either way:
There are a few things about adjustable rate mortgages that can be good or bad, depending on how you look at them. Different lenders offer many different kinds of adjustable rate mortgages, so it's important to do research and find out if it's right for you. Some of the "fuzzy" things you need to think about can make or break your decision to get an adjustable-rate mortgage.
One of the first things you need to think about is whether or not the mortgage has a lifetime interest rate cap. This is the most the interest rate can go up during the life of the mortgage. There are also periodic adjustment caps that limit how much your mortgage interest rate can go up from one adjustment period to the next. The law says that there is some kind of lifetime limit on adjustable-rate mortgages.
Most lenders base their interest rates on one of the index rates. The index rates change and go up and down as the economy does. The lender adds a margin (a percentage of profit) to the index rate to figure out the interest rate you will have to pay. With an adjustable rate mortgage, the margin that the lender adds is also important because it affects your future interest rates. Different lenders have different margins, so it's important to find out what it is.
