A mortgage is a loan that you get from a bank to buy real estate. The mortgage loan is returned to the bank on a pre-established schedule with added interest. With a fixed rate mortgage, the interest rate is set at an amount and remains “fixed” for the duration of the mortgage.
An adjustable interest rate mortgage (ARM) is a loan that has an adjustable interest rate. The initial interest rate is fixed at a certain level and can change over the life of the mortgage.
ARM can fluctuate depending on many factors beyond the control of the lending institution. Interest rates on US Treasury bills are a factor in the regulated rate as well as the national average mortgage rate. Typically, ARM is renewed every one, three or five years, with the advantage of the first term being a lower amount of interest than with a fixed rate loan.
ARM loans can be beneficial for some and disastrous for others. If you are concerned that an increase in interest rates may make it difficult or impossible to meet your loan obligation, it is recommended that you use a fixed rate loan. If you think interest rates will only go down, an ARM loan may be the best way to finance your real estate purchase.
All ARMs have interest rate caps. The payment limit is how much your monthly payment will increase with each adjustment. This is sometimes referred to as the general limit. Some ARMs have a periodic cap that caps the increased interest rate for each adjustment.
Be sure to ask your loan officer about any concerns you may have as ARM has many other factors. Before you choose between a fixed rate mortgage and an adjustable rate mortgage, it is your lender’s responsibility to provide you with any information you need in writing to help you make an informed decision.
What is Adjustable-Rate Mortgages?
The use of an adjustable rate mortgage is always available to those who are interested. The rate varies, and it changes depending on several different factors in the economy. These ARMs will work in the same way as the other lending options available. The only difference people will find is that the interest rate fluctuates, which means that sometimes a person can pay less or more over the course of a year on their mortgage.
More often than not, ARM is offered with a fixed interest rate for the first few months or years of the mortgage. However, at the end of the introductory period, the regulated rate comes into play and the person may start paying more or less depending on the economy.
Adjustable mortgage rate is calculated using indices that help determine the rate people are charged. In the United States, there are six indices that lenders use to determine the variable interest rate. These include: interest rate on exchange of bank promissory notes, national average contractual mortgage rate, Treasury Fixed Maturity Index, 11th Circuit Value Index, 12 Month Average Treasury Index, and Proposed London Interbank Rate.
The ARM interest rate is adjusted according to these indices. For example, if the indices are down 2% along a line, it is more than likely that the interest rate for ARM will drop 2%. Thus, a person can end up saving a lot of money because they chose ARM. On the other hand, if the indices rise by a huge percentage, then the person will pay a very high mortgage payment.
If a person has an ARM, they are notified in writing when they see a change in the interest rate. The letter will indicate the current state of the indices so that the borrower knows why the interest rate is being raised.
Types of Adjustable-Rate Mortgages
Here’s a quick look at the different Types of Adjustable-Rate Mortgages (ARM):
- Option ARM’s
- Negative Amortizing ARM’s
- Hybrid ARM’s
- Interest-Only ARM’s
An Option ARM is an adjustable rate mortgage that lets you choose between different payment options each month. The options usually include a traditional payment of principle and interest option, an interest-only payment option, and a minimum or limited payment option.
Generally, a traditional payment of principal and interest options reduces the amount a borrower owes on their mortgage. The payments are based on a set loan term, such as 15-year or 30-year payment schedule. Interest-only payment options allows the borrower to pay the interest only, however this method does not reduce the amount you owe on your mortgage as you make your payments.
The minimum or limited payment option may be less than the amount of interest due that month, however it may not reduce the amount you owe on your mortgage. With this option, the amount of any interest that is not paid is added to the principal of the loan, increasing the amount you owe, as well as increasing future monthly payments and the amount of interest you will eventually pay over the life of the loan.
There’s also a chance this could turn into a balloon payment. If you only pay the minimum payment during the last few years of the loan, you’ll owe a larger payment at the end of the loan term.
With an option ARM, you have at least two fully amortized payment choices; paying off your loan on schedule through a fully amortized 30-year loan, or paying it off faster and building equity quicker through a 15-year loan.
Regardless of which payment option you choose, you can still pay more towards your principal amount during the life of the loan. Those who only want to own their property for a short period of time, say for ‘flipping’ purposes, should consider this type of home loan. It’s affordable and flexible.
Option ARM Payment-Options
As mentioned, before you have at least two types of fully amortized payment options. However, you also have two more payment options to better suit your situation. They include:
30-Year Fully Amortizing Payments
15-Year Fully Amortizing Payments
The 30- and 15-year payment options guarantee a borrower that the loan will be paid off on schedule. When utilizing the interest-only payment option, monthly payments never go towards the principal balance unless specified.
And with the minimum payment option, the risk may be too great with the fluctuating interest rates after the initial period. If you do choose to apply for an option ARM, make sure you weigh all options from several different lenders. You may also want to get involved and educated about the index rates, as they can affect your interest rates.
Benefits of Option ARM’s
Depending on your reasons for applying for an option ARM, this could be a good or bad idea. There are many benefits to option ARM’s, such as:
Can choose to pay off loan in 15-year or 30-year installments
Affordable and flexible
Gives borrower freedom to choose monthly payments
Perfect type of loan for someone who doesn’t plan on living in home for long
Initial low monthly payments
Drawbacks of Option ARM’s
Could turn into a negative amortizing loan
Could end up having a balloon payment at end of loan
Payments may not cover interest that is due
Payments may not be made towards principle for a long period of time
Payments start low then gradually increase
Negative Amortizing ARM Loans
Usually, the mortgage payment a borrower makes each month goes two places: the interest goes to the lender and the amortization to the principal. Amortization means ‘reduction in the loan balance’, or the amount you still owe the lender. Negative amortizing loans are when you not only don’t reduce the loan balance while making monthly payments, but the loan balance increases.
Typically, the interest rate on a negative amortizing loan, (also called an option ARM) is very low for the first few months. After that, the interest rate usually rises to a rate closer to what other borrower’s rates are.
Now, usually your payments during this first year are based on the initial low rate. Many times, borrowers only pay the minimum amount due each month, which does not reduce the amount you owe and it probably won’t cover the interest due.
This unpaid interest is added to the amount you owe on the mortgage loan, increasing the mortgage balance. This results in negative amortization, meaning that even though you’ve been making payments for a long time, you owe more at the end of the loan life than you originally did when you got the loan.
However, borrowers do have the option to pay the minimum monthly payment, or the fully amortized amount due to avoid a negatively amortizing loan.
Negatively Amortizing Loan Advantages
Believe it or not, there are some advantages to a negatively amortizing loan, including:
- Stable payments
- Low interest rates relative to the market at any time
- Pay back money borrowed today at a depreciated value year from now due to inflation
Negatively Amortizing Loan Disadvantages
Some of the disadvantages of a negatively amortizing loan include:
- Tend to have teaser rates
- You never know when it will adjust
- May not be able to afford payments month-to-month
With most ARM’s, interest rates adjust every 3-months, 6-months, annually, 3-years and 5-years. However, interest rates on negatively amortized loans can adjust monthly.
Depending on your personal intentions of the loan, such as whether or not you plan on living in your home for more than 5-7 years, a negative amortizing loan could be a major problem, since it will take even longer to pay off your loan in full.
The best thing you should do when applying for an ARM, is ask your lender about all possibilities and options if you were to get into a negatively amortizing loan situation.
Pros and Cons of Negative Amortization Loans
Above there are a few advantages and disadvantages of negative amortizing loans. Hopefully here, you will learn more details about each.
See, these types of loans are great for people who have very little to contribute toward a monthly payment, or for those who don’t plan on living in the home for a long period of time.
Low monthly payments during the initial term of the loan help people in financial hardships, and they can actually turn a profit if the home is sold quickly after purchasing.
However, this loan is not always for everybody, even these types of people. The biggest disadvantage of negative loan amortization comes when the homeowner is ready to sell.
If they’ve lived there for several years, or a few years longer than anticipated, it’s possible that the loan amount has become larger than the amount they can sell the house for. This means once the house is sold, the borrower could end up with no profit, and worse, they could end up owing the bank the difference immediately to pay off the original loan.
This could lead to devastating financial consequences for a borrower, as their credit score is likely to drop drastically, and bankruptcy and foreclosure are sure bets. Understanding negative amortizing loans beforehand is crucial to one’s financial future.
With a hybrid ARM, the interest rate is fixed instead of adjustable during the initial period of time, or term. It then ‘floats’ after that. The word hybrid refers to the ARM’s blend of fixed-rate and adjustable-rate characteristics. Many times, people see Hybrid ARM’s advertised as 3/1 or 5/1 ARM’s. Sometimes, people see 7/1 or 10/1 ARM’s, although those loans are rare. So, what do these numbers mean? Just remember that:
The first number tells you how long the fixed interest-rate period will be, and
The second number tells you how often the rate will adjust after the initial period
For example, a 3/1 for an ARM is a 3-year fixed interest-rate period and a subsequent 1-year interest-rate adjustment period. The date that a hybrid ARM shifts from a fixed-rate to an adjustable-rate is known as the reset date.
After the reset date, the hybrid ARM loan floats at a margin over a specific index (same as any other type of ARM). Like other ARM’s, the risk transfers from the lender to the borrower with a hybrid ARM. This allows the lender to offer a lower note rate in many interest-rate environments.
Advantages of a Hybrid ARM
One of the biggest advantages of a hybrid ARM is the rate you get during the initial fixed period. It’s low and very affordable, plus it allows borrowers to plan for their future financially. This could be the perfect solution for an investor, or someone who knows they will not be in the home after the initial fixed period.
Once the fixed period is over, the borrower can expect higher monthly payments as a result of the adjusting previous interest rate to the current interest rate. This will lead to decreased cash flow, and ultimately it can cause default in the loan. So, advantages include:
Low and affordable rates during the initial period
Allows borrowers to plan for the future financially
Disadvantages of a Hybrid ARM
Hybrid ARM’s can be risky for those who wish to remain in the household after the initial fixed period. During the adjustment period, it’s not guaranteed that the rates will change just once.
Borrowers assume the risk that their monthly payments could change month-to-month for the remaining life of the loan. Talk with many different lenders before choosing a specific hybrid ARM loan. They can be tricky in an economic crisis like we live in today. So, disadvantages include:
Could result in a negative amortization loan if residing in residence after initial period
Rates drastically increase, along with monthly payments after the initial period
Who Applies for Hybrid ARM’s?
Anyone and everyone can apply for a hybrid ARM. The important thing is that whoever is applying should understand all options, terms, consequences and benefits before signing up. In most cases, it truly depends on your intentions.
Hybrid ARM’s are only good for those who are going to live in the home during the initial fixed-rate period, but are going to either sell or refinance before the initial period is over. Anyone who plans on living in the home for more than the initial period should probably consider a different type of mortgage loan, such as a fixed-rate mortgage.
ARM is an adjustable rate mortgage in which the borrower only pays the interest on the loan for a specified period of time. This is usually a short period, such as one, five or seven years. The interest rates on these loans are currently very low, but since they are regulated by the lender without any involvement of the loan holder, the borrower may end up paying much more than he started paying if lenders raise their interest rates.
A loan that starts at 3.50 percent may end up at 6 or 7 percent, with payments much higher than the borrower could expect. Because these interest-only payments do not include payments on the principal, the payments are usually very low.
ARM percentages only. This can be a good option for those who are saving and investing money that they don’t pay every month, excluding their home loan principal payments. The goal for many people is to earn high interest on the money they invest, hoping to then easily pay off their mortgage when the ARM only runs out of interest.
In addition, borrowers can borrow a different percentage of ARM only more than once, when one expires. This can be equal to 15 years or more of paying only interest and a lot of money saved.
This type of loan can be obtained by young couples who know that their income will increase significantly in the future. This includes highly paid professionals such as doctors and lawyers. Investors are another group that sometimes only use ARM interest to have cash to invest in Forex or the stock market. They realize that they can probably make more money from their investments than they would have made from investing in their home.
Real estate investors also use these loans, which require much lower payments than regular mortgages. Using ARM percentages alone can be risky for these reasons. If an investor loses money saved by not paying the principal over and over again, then ARM may not be a good investment.
The rates for the ARM interest rate alone are between 3.44 and 3.90 percent, while the 30-year fixed loan currently has an interest rate between 4.83 and 5.03 percent. These loans are available but sometimes difficult to find. In fact, all home mortgage loans can be difficult to approve in a low economy, even for those with excellent credit ratings.
You will have to pay about a half a percent higher rate with an adjustable rate mortgage than with a standard ARM, which requires payment of principal in addition to paying interest.
There are bad home loans, but in today’s slow market, they are also hard to find. Some lenders do not currently lend to a very large number of clients, let alone bad loan seekers. Specialized lenders specialize in bad credit applications and sometimes accept people who have bankruptcies, write-offs and other negative marks on their credit history.
This group could potentially get an ARM at a fixed rate for up to seven years. Government and subprime lenders often lend to those with bad credit through VA or FHA mortgages.
When the short interest payment period just ARM ends, the borrower begins to pay both principal and interest in regular monthly installments. If the borrower’s income has not increased significantly or has not had a good ROI, it could be a financial shock when much larger payments are required, including the principal.
In addition, there is a possibility that the borrower will owe more interest than is required for the entire life of the loan. In this case, additional payments are required at the end of the loan.
Is an adjustable rate mortgage right for you?
Adjustable rate mortgage loans, or ARM, are loans from credit institutions to buy real estate. Fixed rate mortgages are also available for the same purpose. The main difference between a fixed and an adjustable rate mortgage is the interest rate you will pay on top of the face value of the loan.
An adjustable rate mortgage changes the interest rate based on factors such as the rate on US Treasury bills or the base rate. Every mortgage holder has the benefit of a maximum interest rate with an adjustable rate mortgage. The interest rate limit, called a ceiling, can be reset every year.
Although an adjustable rate mortgage usually has lower interest rates initially than a fixed rate mortgage, there is a risk of a higher interest rate as the mortgage lasts for its entire life. If you see signs of declining interest rates over the life of your mortgage, the adjustable rate might be for you.
Before making a decision, there are many factors to consider related to mortgage interest rates. If the interest rate goes down over the life of your loan, you may end up paying a lot less than with a fixed rate mortgage. If you are planning to own your home for the long term, this is worth considering.
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