Investopedia.com defines an adjustable-rate mortgage as “a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan. Normally, the initial interest rate is fixed for a period of time, after which it resets periodically, often every year or even monthly. The interest rate resets based on a benchmark or index plus an additional spread, called an ARM margin.”
The borrower assumes the risk of interest rate fluctuations, as opposed to a fixed-rate mortgage, which does not change for the length of the loan. In a market where fixed-rate loans are very low or increasing, like the current market, I LOVE FIXED-RATE. I only like adjustable when the borrower fully understands them and how to use them. They are a tool. There are times when they can save you money. (One example is if you are going to own the home for substantially less time than the fully amortized fixed-rate term.)
With an ARM, the early payments can be substantially lower, but can increase up to a given rate cap. Sometimes the loans are structured in such a way that the payments do not increase quickly enough to offset the increasing loan balance, and the loan principle is actually INCREASING. These are called “negative amortization” loans. Many people have gotten in trouble with these loans when not understanding the underlying structure.
These loans can be a good tool when you need flexibility in your payment schedule, like sales people paid on commission. They commonly have four payment options:
- Minimum payment (less than amortized amount)
- Interest only (does not reduce principal)
- 30-year payment (will pay off loan on a 30-year schedule)
- 15-year payment (will pay off loan on a 15-year schedule)
The other attractive feature of these loans is demonstrated by the example of the commissioned sales person that has big year and pays extra on the mortgage. The salesperson has the benefit of lower payments required every month for the balance of time left in the loan, because they are essentially re-cast to be amortized over the remainder of the 30-year term.
I once used an ARM in purchasing an apartment building that needed upgrading and some change in the tenant base. The arm allowed lower payments while the vacancies and repairs were happening.
Again, the typical homebuyer or homeowner plans on staying a long time, are the logical choice in a low-interest rate environment with an expectation of higher rates to come, is absolutely a fixed-rate product.
See my blog post on Fixed-Rate Mortgages.
For more useful information, visit my website at CALLDAVE.com.
Home and Investment 