Adjustable Rate Mortgage

Adjustable rate mortgages (also known as ARMs) are one of the most common types of mortgages for homeowners. Adjustable rate mortgages have an adjusting interest rate that is tied to an established index. Your monthly payments will actually vary based upon several factors that are actually beyond your control. The decision between an adjustable rate mortgage and a fixed rate mortgage is a very important one depending upon your financial circumstances. The decision, like any major life decision, requires careful thought and consideration.


1. Why Are Adjustable Rate Mortgages So Popular?

Adjustable rate mortgages have become popular because people do not stay in their houses for as long as compared to previous generations. For this reason, a lot of homeowners are looking to keep their initial monthly payments low. If the homeowner plans to stay in the house for five years or less, an adjustable rate mortgage may contain lower interest rates compared to fixed rate loans. That is one of the reasons for the increased popularity of adjustable rate mortgages. Plus, consumers like having more disposable income available, and adjustable rate mortgages can sometimes free up money each month, especially for homeowners who are having difficulty making ends meet.

If you're the type of consumer who is purchasing a home following the traditional way of having a 20% down payment, then an adjustable rate mortgage might not make sense for you. Adjustable rate mortgages are a much more popular option for consumers who are using alternative methods to purchase their homes. Young professionals just starting their careers find adjustable rate mortgages to be a good option, especially if they're carrying a lot of student loan debt.

Before applying for a mortgage, it's best to carefully evaluate your situation to determine what type of mortgage is the best option for you. Some consumers know this either intuitively, or because they have a preference. If you don't have a preference, or would like to learn more about adjustable rate mortgages, read on to determine how adjustable rate mortgages might fit into your goal of homeownership.

2. Teaser Periods

Some adjustable rate mortgages provide the new homeowner with teaser rates. The teaser interest rates will be lower than the index rate for a specified period of time. With the low interest rate, many first time homeowners will be able to afford the payments to make homeownership possible. However, the catch to homeowners is that the teaser rate will not last forever, and this could make the risk of foreclosure higher In the future. Budget accordingly, so you can easily handle wide fluctuations in your interest rates both now and in the future.
Taking a teaser rate is not that risky if real estate prices go up during the time that you have your adjustable rate mortgage. The reasoning is that the homeowner will have the opportunity to refinance using the equity in the appreciated home value to make the mortgage payments lower. However, appreciating real estate prices in the short term are not always a certainty. Clearly, the teaser rate period of adjustable rate mortgages may subject the buyer to more risk than the traditional rate mortgages, but that's not always a bad thing.

It's always advisable to read your paperwork carefully before taking out an adjustable rate mortgage. Also, make sure you retain all copies of any paperwork you do receive for as long as you own the home, even after your mortgage is paid off.

3. Loan Caps

To reduce some of the risk for the homeowner, most adjustable rate mortgages contain a loan cap. Loan caps are fairly complicated, and every adjustable rate mortgage contains different terms. There are three important types of loan caps: Initial Adjustment Rate Cap, Rate Adjustment Cap, and Lifetime Adjustment Cap.

Generally speaking, the initial adjustment rate cap is a fixed interest rate above the start rate of your adjustable rate mortgage. On most adjustable rate mortgages, the standard initial adjustment rate cap is 3% for the initial fixed rate term of three years. When the initial fixed rate is five years or greater, a cap of around 6% is common in most adjustable rate mortgages.

To protect homeowners from extraordinary initial adjustments, adjustable rate mortgages contain a rate adjustment cap. The rate adjustment cap is the maximum amount the interest may increase on each succeeding adjustment. Standard rate caps are 1% for the initial fixed term of three years, and 2% for initial fixed terms of 5 years or greater.

Subject to the credit scores of the borrower, adjustable rate mortgages contain a lifetime adjustment cap. This range is usually between 5% and 7% of the start rate in your adjustable rate mortgage. The better the credit scores, the lower the lifetime rate cap will be in the adjustable rate mortgage. That's why it's important to pay close attention to your spending and payment history in the period of time before you plan to apply for a mortgage. You'll definitely want your credit score to be as good as possible before applying for a mortgage, so you qualify for the best deal possible.

To avoid getting in over your head with adjustable rate mortgages, the borrower should calculate the monthly payments assuming interest rates go as high as the adjustment cap. This is the worse case scenario, and borrowers should factor this into their decision-making process.

4. Adjustable Rate Mortgages versus Fixed Rate Loans

Traditionally, adjustable rate mortgages will offer a lower rate compared to a thirty year fixed rate loan. Longer term fixed rate mortgages will provide rates higher than shorter-term adjustable rate mortgages because of the risk to the lender. If future interest rates drop substantially, the borrower will end up paying more interest in the fixed loan compared to an adjustable rate mortgage. Predicting future interest rates is extremely difficult, even for a professional economist, but it's still best to learn all you can before applying for any type of mortgage, including fixed rate mortgages.

Whether an adjustable rate mortgage is a good fit for you will depend upon your psychological view towards money. Many borrowers are extremely uncomfortable with the fact that their mortgage payments will be higher in the future. These people should avoid adjustable rate mortgages because they may make the borrower extremely uncomfortable. Other borrowers understand that future interest rates are often unpredictable and do not mind paying more interest in the future if they have the opportunity to save money in the short term. When making this decision, you have to decide what makes you feel most comfortable.

5. Prepayment

Adjustable rate mortgages are similar to other types of mortgages that allow the borrower to pay off the loan sooner than the payment terms. In the event that interest rates rise, the borrower may pay off the loan earlier so less interest is paid. To pay off the loan earlier, it may be prudent to tap into other personal savings to avoid paying all the higher interest rates. Many consumers enjoy prepaying on their mortgage because they like the security of owning the home in full without having a mortgage. Again, your personal view of money and finance comes into play here.

Although this is a great option for some borrowers, the majority of borrowers do not have the means to pay off the loan early. "Payment shock" is actually the industry term for unexpected rising monthly payments to the homeowner due to rising interest rates. Some consumers don't like the uncertainty of not knowing what their interest rate will be, even if it means they'll enjoy less interest in the short term.

6. Converting An Adjustable Rate Mortgage To A Fixed Loan

It is easy to convert an adjustable rate mortgage to a fixed loan if the mortgage contains a convertible clause. This type of adjustable rate mortgage will allow the borrower to convert to fixed rate loans at specified times throughout the year. If your adjustable rate mortgage does not have a convertible option, then the borrower will have to refinance the entire loan with that lender or a new lender. Refinancing does come with the cost of application fees and closing costs on the new loan. Although, depending upon the term of the original adjustable rate mortgage, refinancing may save you money in the long run.

7. Adjustable Rate Mortgages For The First Time Homeowner

Adjustable rate mortgages provide a window of opportunity for the first time homeowner to qualify for a mortgage. A tremendous amount of first time homeowners will qualify for an adjustable rate mortgage, but may have trouble qualifying for a fixed rate mortgage. If this example describes your situation, but you're leery of adjustable rate mortgages, you'll have to decide how important homeownership to you is at the present time.

From the lender's point of view, adjustable rate mortgages provide borrowers with initial lower payments than fixed mortgages. Therefore, the lender could justify the loan because the payments will be within the borrower's monthly budget. This could be good news for borrowers if they expect their earnings to rise in the future, so they can make higher monthly payments when interest rates rise. On the contrary, future monthly payments will result in payment shock if borrowers can't afford them. This is perhaps one of the most important considerations when deciding whether or not an adjustable rate mortgage is for you.

8. Home Equity Lines Of Credit

Adjustable rate mortgages are not home equity lines of credit. Home equity loans create a second mortgage against your house using the available equity in your house. This allows the borrower to have cash to consolidate other bills or make needed home improvements. With an adjustable rate mortgage, you may have the opportunity to draw against the equity in your home if real estate prices increase in your neighborhood. A fixed rate loan most likely will allow the buyer to build equity faster compared to an adjustable rate mortgage because more money is being paid on the principal during the early portion of the loan. Although the homeowner may have equity in their home, the borrower must be approved from a lender before a home equity line of credit can be drawn.

9. Saving Money On Adjustable Rate Mortgages

An easy way to save thousands of dollars on your adjustable rate mortgage is to build your credit score. To raise your credit scores, you need good established credit, in part by paying your bills on time. If you have had bad credit in the past, then time will help repair your credit provided that you pay your bills on time. In addition to paying your bills on time, you should strive to keep your balances low compared to the upper limit on your credit cards. This will improve your credit scores, therefore, saving you a ton of money by helping you qualify for a lower interest rate on your adjustable rate mortgage. Outside of mortgages, bad credit will cause you to pay more for car loans, credit cards, and insurance. Credit scores are paramount for personal financial success in modern society.

If a borrower has bad credit, then that leaves two options for the would-be homeowner: repair your credit before you purchase an adjustable rate mortgage, or deal with the sub-prime interest payments on your mortgage. Also, it may be wise to verify that your credit report is accurate.

Make sure you shop around. Look at different lenders. You're not obligated to apply for a mortgage with a lender just because you inquired about a quote. Also, you're not obligated to go with the same lender you've used in the past for personal or car loans. Sometimes, going with your usual lender might work to your advantage, but sometimes it won't. See what rates your usual lender can give you, but also get quotes from several other lenders to determine what your best option is. If you don't shop around, you won't know if you're getting a good deal. Don't limit your options by not investigating and evaluating all your options.
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