Adjustable Rate Mortgage: The right way to use it

Buying a home can be a monumental effort, both financially and psychologically. As most buyers cannot afford to purchase the property upfront, applying for a loan becomes obligatory. The amount borrowed as a loan is known as mortgage and is made up of various components. It usually includes the collateral, the principal amount and the interest levied, along with the taxes and insurance.

An adjustable rate mortgage (ARM) is a type of loan in which the interest rate keeps changing. It is also known as the variable-rate mortgage, as the interest rate on the balance amount is adjusted periodically after a given period of time. The adjustment is based on an index that depicts the borrowing cost of the lender in the credit market.

Typically, an ARM is expressed in two ways. The first method uses two numbers where the first digit indicates the duration for which the fixed-rate is applied, while the second usually indicates the period for which the floating rate is applicable. For instance, a 3/28 ARM would mean the fixed rate is relevant for 3 years, and the floating rate for the remaining 28 years. In another method, the second numerical indicates the duration for which the variable rate gets adjusted. Like in 5/1 ARM, the variable rate gets changed every year, while in 5/5, it is renewed every 5 years.

In ARMs, a substantial amount of risk faced by the lender due to varying interest rates is transferred to the borrower. If the interest rate decreases, the borrower stands to gain, but will lose if the rate increases. The interest rate is usually expected to climb with every passing year. Hence, the borrowers should be able to evaluate as to how long they will be paying a higher interest with the ARM, compared to the fixed rate mortgage.

One of the primary advantages of ARM is the small payments compared to the fixed-rate mortgage.  Also, the interest rate is much lower at the beginning. However, these advantages hold good till the rate is fixed. Once the rate gets adjusted, it may either increase or decrease depending on the future market scenario.

The traditional ARMs with monthly adjusted rates are almost extinct. The ones available are hybrid-ARMs. For these types of mortgages, the fixed rate period ranges from three, five, seven and ten years, and then the rate starts varying annually. Therefore, some of the scenarios for which the currently available ARMs are suitable could possibly include the following:

• When the borrower wants to take advantage of the lower initial rate of the ARM and pays off the loan quickly.
• The borrower is quite sure of selling the property before the fixed rate term of the ARM comes to an end.
• The markets scenario indicates a sure fall in the interest rate in the future.

In addition, when the savings from the lesser payments are carried out over several years, it would amount to a substantial amount.

However, the reputation of ARMs has diminished due to the last decade’s market meltdown. Prior to the crisis, it worked effectively and many who opted for them have benefited from low rates, especially when the loan got converted from fixed to adjustable. Hence, it is imperative for applicants to discuss the options with an experienced loan officer before opting for the Adjustable Rate Mortgages.

Key Takeaways

• An Adjustable Rate Mortgage (ARM) is a type of loan in which the interest rate changes after a given period of time.
• The primary advantage of ARM is the small payments compared to the fixed-rate mortgage.
• When the savings from the lesser payments are carried out over several years, it would amount to a substantial amount.