ARMs or adjustable rate mortgages are loans that have an interest rate that “adjusts” after an initial fixed rate period. How often ARM home loans are adjusted depends on the terms of the loan.
Adjustable-rate mortgages are considered riskier than traditional 30-year fixed-rate loans because if interest increases within the specified restart time, your monthly mortgage payment will also increase. If you don’t budget properly, the monthly payment increase may be too high for your current financial situation, causing you to default on the loan.
ARM home loans are popular because they have a lower initial interest period compared to fixed rate loans. This often allows a borrower to qualify for “more housing” than they would get with a fixed rate loan. Again, the risk is that if the loan is restored in the specified period of 1, 3 or 5 years at a higher interest, the monthly payments will also increase.
Eighty percent of all adjustable rate mortgages fluctuate based on a complex algorithm of indices of one of three indices: 1) the District 11 Cost of Funds Index (COFI), 2) the London Interbank Offer Rate ( LIBOR) and 3) the Constant Maturity Treasury Indices (CMT).
Since ARM loans have the ability to reset at a higher rate than the initial fixed rate, why is it a popular loan for many borrowers? Low initial interest is one factor, and another factor is that risk can be somewhat mitigated by “caps” on the rate variations that are inherent in the loan.
ARM loan limits apply to two parts of the loan: the default readjustment periods of 1, 3, or 5 years and the term of the loan. The reinstatement period limit restricts the amount that rates can change, up or down, in a given period of time and the loan life limit restricts the amount that the rate can change, up or down, during the duration of the mortgage exists.
Adjustable rate mortgages will continue to be a popular type of loan because they are easier to qualify for and the lower fixed rates are very attractive. If interest rates only increase gradually over time and the borrower’s income gradually increases, there is little risk in this type of loan. If interest rates drop, this type of loan can save the borrower a significant amount of money over the life of the loan. ARM loans have proven to be a valuable resource in the mortgage industry.
Only when a borrower purchases an ARM and is at the extreme limits of its borrowing capacity can disaster strike. If the ARM is reset at a higher rate than the borrower can afford on a monthly basis, the result can be foreclosure. Make sure you fully understand the terms of ARM home loans, including planning to increase rates, before signing a contract. If you inform yourself about all the contingencies of this type of loan, you will be prepared to benefit from its advantages.
