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ARM Loans. Are they right for you? Home > Mortgage Research > ARM Loans. Are they right for you? |
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What is an Adjustable Rate Mortgage?
With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount.
It also means that you might qualify for a larger loan because lenders sometimes make the decision about whether to extend a loan on the basis of your current income and the first year’s payments.
Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage—for example, if interest rates remain steady or move lower. Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future.
If you can afford more risk, you may get lower payment
It’s a trade-off—you get a lower rate with an ARM in exchange for assuming more risk. Here are some questions you need to consider:
• Is my income likely to rise enough to cover higher mortgage payments if interest rates go up?
• Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
• How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)
• Can my payments increase even if interest rates generally do not increase?
The Adjustment Period With most ARMs, the interest rate and monthly payment change every year, every three years, or every five years. However, some ARMs have more frequent rate and payment changes.
The period between one rate change and the next is called the “adjustment period.” A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year.
Index
The Index Most lenders tie ARM interest-rate changes to changes in an “index rate.” These indexes usually go up and down with the general movement of interest rates. If the index rate moves up, so does your mortgage rate in most circumstances, and you will probably have to make higher monthly payments.
On the other hand, if the index rate goes down, your monthly payment may go down. Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on one-, three-, or five-year Treasury securities.
Another common index is the national or regional average cost of funds to savings and loan associations. A few lenders use their own cost of funds as an index, which gives them more control than using other indexes.
You should ask what index will be used and how often it changes. Also ask how it has fluctuated in the past and where it is published.
Margin
The Margin To determine the interest rate on an ARM, lenders add to the index rate a few percent-age points, called the “margin.” The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan. Index rate + margin = ARM interest rate
You can read more about adjustable rate loans in the free e-book: Consumer Handbook on Adjustable-Rate Mortgages (27 pages: pdf) |
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