Adjustable Rate Mortgages

Adjustable rate mortgages were created during a period of high interest rates as a viable alternative for prospective homebuyers who were otherwise unable to qualify for a fixed rate mortgage. The biggest feature of this type of loan is that the interest rate is not fixed and will follow market fluctuations.

For the borrower, one of the most appealing features of an ARM, or adjustable rate mortgage, is that the initial interest rate is often much lower that of a fixed rate mortgage of the same value. In a fixed rate mortgage, the lender assumes some risk that if the market fluctuates and interest rates rise, their profit magin will be reduced on a lower interest loan. Because the interest rate on an ARM is free to move with the going market, the lender can offer a short term reduced rate as an incentive for borrowers to take out a loan.

This lowered initial rate can be a real boon for homebuyers who do not qualify for fixed rate mortgages because of the higher interest and subsequent higher payments. Financial institutions will often lend out more on an ARM than on a fixed rate mortgage. Plus the lower rate is especially appealing to borrowers who are working with tight budgets. An adjustable rate mortgage is an ideal solution for those who do not plan on keeping their home for a long time.

There also is private mortgage insurance to consider.  To learn more, read this article.  It also details how much easier it has gotten in the past year to actually get rid of this extra payment as soon as possible.

The way an adjustable mortgage are made possible because the interest is tied to a variable index. An index is measure of the lender's cost to borrow money. Depending on the institution, this index may be tied to such items T-bills, certificates of deposit, and the London Interbank offer rate. It is important when considering an adjustable rate mortgage to know what each potential lender is pegging their index rate on, as some of these indexes are more volatile and subject to fluctuation than others.

At regular intervals, called adjustment intervals, the interest rate will change to reflect the current index rate. This interval can vary greatly from loan to loan, from about every six months to three years depending upon the loan agreement.

Other important items associated with adjustable rate mortgages are interest caps and payment caps. An interest cap is a limit, set by agreement in the loan, of the maximum amount the interest rate can can be raised in one adjustment interval. ARMs are also required to define a lifetime cap, which establishes the uppermost limit the interest can be raised for the entire term of the loan. Payment caps set a ceiling on the total amount of each payment made by the consumer. While this may seem ideal as it keeps payments from climbing beyond a certain amount, the drawback to this is that it can lead to "negative amortization". If the interest rate goes up to the point where the proportional monthly payment is higher than the limit set be the interest cap, the remainder over the limit is added back into the total balance owed. When this occurs, the remaining amount of the loan can actually increase instead of decrease. This can be especially bad if property values are dropping.