How Does an Adjustable Rate Mortgage Work?
As hard as it is to digest the fact that this mortgage is extremely clingy, it’s one of the main reasons you can buy a house for real. So let’s face it, this mortgage buddy is not going anywhere, not in this lifetime it’s not. There are various types of mortgages, but the basic ones are the Fixed Rate Mortgage and the Adjustable Rate Mortgage (ARM). The interest on the fixed rate mortgage loan stays same throughout the term of the loan, whereas the interest on the adjustable rate mortgage loan is based on an index, which reflects the cost to the lender of borrowing on the credit markets. The payments made by the borrower change over time with respect to the change in interest rate. ARM partially transfers the risk for the lender to the borrower. They’re basically used when the future interest rates are hard to predict meaning that the fixed interest rate mortgage is unfavorable.
- Initial Interest Rate- This is the very first interest rate on an ARM.
- Adjustment Period- This is a period where the interest rate does not change. After the passage of this period, interest is recalculated along with the monthly loan payment.
- Index Rate- There’s a common practice to link the interest rate with the index rate. One of the common indices is the national/regional average cost of funds to savings and loan associations.
- Margin- Lenders add this margin percentage to the index rate and use it to calculate the ARM’s interest rate.
- Interest Rate Caps- The caps are the boundaries as to how far or low the interest rate could go in each adjusting period or the complete period designated to the loan.
- Initial Discount- These are the promotional interest rates offered in usually in the very first year.
- Negative Amortization- When the monthly mortgage payments are not enough to pay off all the interest due on the mortgage, the balance of the mortgage increases resulting in negative amortization.
- Conversion- Some of the lenders add a clause to the contract that allows the buyer to convert from the ARM to the fixed rate mortgage.
- Prepayment- Different contracts have different terms and conditions likewise some of the contracts usually have penalties attached to them in case of an early prepayment.
- Low Initial Interest Rates- As mentioned earlier, the initial concession is a plus point. This gives the borrower a healthy heads-up.
- Floating Nature of Interest – The whole motto of an ARM is to keep floating. Whenever the market rates fall the interest rates fall as well.
- Hybrid ARMs- Lenders and borrowers both love hybrid ARMs because a fixed rate mortgage by default converts into the adjustable rate mortgage over a fixed period of time.
- Caps- ARMs work with respect to the caps. They offer protection to not just the lenders, but the borrowers too.
- Initial Rate Increase- The cap rule does not apply to the first interest rate increase so this can backfire.
- Floating Nature of Interest- There are surprises when you’re going for an ARM. If the interest rates can fall, they can hideously rise too!
- Rates Over Time- Another bummer, the same interest rates that were previously lower than the fixed rate mortgage are bound to increase over time and you cannot stop this.
- Frequent Changes- Interest rates on an ARM tend to fluctuate annually, quarterly and even monthly. Frequent changes can put a serious strain on your budget. So this is not really good news but it depends on the terms and conditions of your contract with the lender.
- Refinancing- If you’re planning to switch from the ARM to the fixed rate mortgage, I must tell you it’s no piece of cake. And if you fail to refinance your mortgage altogether, you’re doomed and better kiss your house goodbye!
Like everything else in the world, adjustable rate mortgage loans have a good side and a darker side. If you’re planning to buy a house in Texas and you’re a risk taker, an ARM might be the right choice for you, but if you’re a risk averter then it’s better to stick with the fixed rate mortgage loan. There’s no doubt the fixed rate loans have no hidden surprises are more stable in nature. ARM benefits cannot be totally ignored. They can be extremely attractive in times when there’s an exceptional fall in the interest rates, but at the same time they can put you in a lot of trouble and not everyone can handle the stress it brings into the lives. Explore your options wisely, understand them, weigh them and only then take a decision. For more information, contact our ARM Loan Specialist.