The Adjustable Rate Mortgage as Long Term Loan

by : Stefano Sandano

Adjustable rate mortgages are long term mortgage loans with variable interest rates. They have a schedule of principal and interest payments just like a fixed mortgage, but the interest rate may be adjusted at regular intervals during the term of the loan. Therefore, the monthly payments are likely to move up and down as the rate is adjusted.

An ARM is an important financing alternative for first and second mortgages. In addition, many home equity loans are structured as adjustable rate mortgages.

In addition to the contract interest rate, discount points, loan to value ratio, and maturity, ARMs have their own unique set of terms:

- Adjustment Interval: most ARMs are adjusted at regular intervals stated in the mortgage contract. In between these intervals, the interest rate on the loan is constant. The shorter the interval, the more sensitive the loan is to changing interest rates. Most first ARMs are adjusted annually

- Initial Interest Rate: all ARMs have an interest rate that is fixed until the first adjustment date. Sometimes this rate is set low to attract borrowers, called a teaser rate. Therefore, the initial interest rate does not indicate the long term cost of the loan.

- Convertibility: some ARMs provide the borrower with the option to convert to a fixed rate loan during the loan term.

Because your payments almost always rise later on, some detractors call it a compact with the devil. Nonetheless, an Arm in some markets can cut your initial payments by as much as a third. That can mean the difference between being able to purchase and being left out in the cold.

The best way to understand an ARM is to compare it to a fixed-rate mortgage. With a fixed-rate mortgage you always know where you stand. Your interest rate and your monthly payment remain constant for the life of the loan whether it is for 3 years or 30 years.

With an ARM, it’s quite different. Your interest rate fluctuates, it moves up and down depending on market conditions. Your monthly payment, which reflects the interest rate, likewise can vary up or down over the life of the loan.

Given a choice between a mortgage where you never know what your monthly payment is going to be, and a mortgage where the monthly payment is fixed, any reasonable person would opt for the fixed-rate mortgage. The real key to deciding whether or not to get an ARM is how long the teaser rate lasts. If you get an initial low interest rate and payment for just 1 month, and then it goes up, you have accomplished almost anything.

On the other hand, if the low monthly payment lasts for several years, it can be just the right thing, particularly if you sell or refinance when the teaser expires. In fact you want the teaser to be for as long as possible so you get a lower monthly payment than you otherwise would get. Second, you hope that once the teaser evaporates and your interest rate and payment go up, you can refinance to another ARM with another low teaser.