Are Adjustable Rate Mortgages Bad?

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Ever want to know what an adjustable rate mortgage is, but simply haven’t taken the time to read up about it. You probably have heard about these types of mortgages during the financial crisis. But the truth is that an ARM does have a valid place in the marketplace. You just have to understand what it is, and how it works. Yes it does carry more risk than your standard conventional mortgage. But this risk can be minimized.

Remember that your standard or fixed rate mortgage never changes. You make the same monthly payment for the entirety of the loan. If you are on fixed income, then this might be the one option for you. There are no surprises.

How an ARM Works

The one difference between an adjustable rate mortgage and your fixed rate, is that the rate can change.  There are many different types of ARM’s, but we will discuss one of the most popular, which is the 5/1 ARM.  

5/1 ARM

The 5 stands for amount of years the mortgage rate cannot change. Your payment will be the exact same for 60 months.  After 5 years passes then the real fun begins. This is when the rate on your mortgage may change. It can go up or down based upon the index rate.  But given how our interest rate climate has been so low for so long, it’s a safe bet that it may go up. But there are caps in place that will limit how much the rate can change.

Now after the initial 5 year  period is over, your interest rate will reset once a year for the remaining term of the mortgage. Remember, ARM mortgages like the 5/1 may be for a total of 30 years.  So in essence, it can change every year for the next 25 years, if you stay in the home, and with the same mortgage. You might compare the reset like you might renewing an Austin apartment rental. They are usually around 12 months and apartment rents normally do change once a year.

That is pretty much it. There aren’t any specific rules that say you cannot sell or potentially refinance your home. But you will want to read over your mortgage contract. You should also be aware that ARM mortgages start out with a lower interest rate than your fixed. That is the main benefit. So you can afford more home with an ARM.

You could use that extra money to pay off student loans, a car loan, or other debt. It’s also a good idea to consider an adjustable rate mortgage if you expect to be making more money in the next 5 years.

Rate Caps

There are a couple of other items that you will want to know.  There are rate caps on both how much the rate can reset per year, and over the life of the loan. This is to prevent shock, plus make you aware of how much the rate can change before you agree to the terms of the loan.

Mortgage Index

For those of you still counting, you will want to know what determines whether your rate will go up or down. There are a few mortgage indexes that rates are tied to. These are the CMT, COFI,  and the Libor indexes.

Advantages of an ARM

  • Lower Initial Interest Rate than a Conventional Mortgage
  • Lower mortgage payment
  • If rates go down, you might have a lower payment

What are the Risks

Simply put, the risks are that your rate may go up, which equates to a larger home payment. If you are on a fixed income, this can potentially put you in a scary position. But there are ways to offset this risk. You can also sell or refinance potentially.

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