An adjustable-rate mortgage, also known as an ARM, is one of the two major types of mortgages. Unlike fixed-rate mortgages, ARMs include provisions that allow for the rate of interest that the borrower has to pay on the mortgage loan to change over the course of the mortgage term. As a result, ARMs can become less expensive for borrowers if future interest rates fall, but they also risk becoming more expensive if interest rates rise.
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Key Attributes of an ARM
- Mortgage rate varies with prevailing market interest rates: ARMs start by charging an initial interest rate set by the lender. After that, on a regular basis -- usually every year -- the mortgage rate gets reset. The ARM will refer to a specific index interest rate that it uses to calculate each year's new ARM rate, typically by adding a certain percentage amount to the index rate.
- Monthly payments can change: Because monthly payments are tied to the interest rate on the mortgage, the amount you pay can change throughout the course of the ARM's term. If interest rates are higher when your ARM resets, your new monthly payment will rise to reflect the greater amount of interest charged. When rates fall, your monthly payment will fall.
- Caps limit how much rates can change: To protect borrowers from extreme interest rate swings, most ARMs set caps on how much a rate can change. Separate caps can apply both to the maximum amount that the rate can move in any one year, as well as to the total amount the rate changes over the entire term of the ARM.
Pros and Cons of ARM Mortgages
- Why ARMs are attractive: The initial interest rates on ARMs tend to be lower than on fixed-rate mortgages, giving ARM borrowers cheaper monthly payments at the start of the mortgage than they would get on fixed-rate mortgages. The fact that payments are lower means borrowers can often qualify for larger mortgages if they use an ARM than if they choose a fixed-rate mortgage. Also, in falling rate environments, ARM borrowers benefit by seeing their payments go down.
- Why ARMs are risky: Many ARMs offer "teaser" rates initially, meaning that it's likely the ARM rate will rise at the first reset period even if prevailing interest rates stay constant. Also, the borrower assumes the risk of rising interest rates. If rates climb, then monthly payments can become more expensive than the borrower can afford, potentially endangering the borrower's ability to repay the mortgage loan and causing default or foreclosure.
Adjustable-rate mortgages can be useful tools for would-be homeowners, but they involve taking on interest rate risk. Before using an ARM, be sure you know exactly what the worst-case scenario is and make sure you can handle the consequences if it occurs.
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The article What Is an ARM Mortgage? originally appeared on Fool.com.
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