One of the choices a new homeowner will have when applying for a mortgage is if the interest rate is to be adjustable or fixed. Adjustable rate mortgages explained in simple terms (or ARM) means that the interest rate of your loan will adjust with the national average. A fixed rate mortgage has a fixed interest rate that does not change.
There are debates on either side of the adjustable rate mortgage option. It is important to understand what a purchase of a home with adjustable rate mortgage really is to decide if it is a good choice.
Types and Limits of ARM Rate Adjustments
The interest rate for a new ARM is typically lower than a conventional fixed rate loan. It is adjusted with either one-year treasury rate, LIBOR index or the COFI index. The rate does have a limit, so there are no worries about it getting terribly high. In most cases, the rate cannot increase by more than two points per year and no more than six points for the life of the home loan.
When homeowners purchase a home with adjustable rate mortgage the interest rate begins lower than the index followed. Timing for rate adjustment period will vary by lender. The most common ARM terms are for adjustments once per year. Some lenders will adjust monthly or up to several years, depending on the life of the loan.
Some lenders use an interest only program for a home loan. The terms of this loan the borrower will pay only interest payments for the first five years of a loan. After five years, principal is added to the monthly payment. As this is an adjustable interest rate, the payment could be considerably higher. Many homeowners who choose this option will refinance before the initial five years has ended.
Pro’s and Con’s
This type of mortgage appeals to borrowers with lower income or credit rating. The ARM rate begins low allowing for lower monthly payment options. Lenders must apply the “Ability to Pay” rule to insure that the borrower can afford to pay the loan payments for the life of the loan, including higher interest rates. Using this rule protects the borrower from over spending and going into foreclosure.
With adjustable interest rates, payments can often rise. A borrower must be prepared to pay higher monthly payments as the loan matures. Depending on the terms of adjustment, some borrowers may owe more than the loan value at maturity. Some ARM terms include penalties for the borrower making more than the actual payment.
Homeowners with an existing higher fixed rate mortgage will sometimes choose to refinance to an adjustable rate mortgage when they need to lower payments or to avoid foreclosure. Refinancing for better terms is common with long-term mortgages. Switching to an adjustable rate will often result in lower monthly payments.