In general, there are two major types of home loans: adjustable Rate Mortgages (ARMs) and fixed rate mortgages. With an adjustable mortgage, the interest rate you are charged can change over time. Usually a lender will select an index rate, then add their margin to come up with the actual rate you will be charged. Most index rates mirror the economy, so you can expect your rate to fall as the economy struggles, or to rise during times of growth.
Most ARMs also have a fixed introductory period where the interest rate will remain stable. During this period, which can last for as little as a month or as long as a few years, depending on the type of loan, ARMs tend to be cheaper than comparable loans available at fixed rates. ARMs are therefore a good option for borrowers who intend to stay in their homes for less time than the introductory period on an available ARM. However, borrowers who end up staying for longer than they intended might end up having to pay to refinance into a more stable loan type.
In addition, ARMs are often used by borrowers who cannot get a fixed mortgage at a good rate. For many borrowers, the first few years of a fixed rate mortgage can be tough, as there is very little room between their income and their mortgage. ARMs allow these buyers to purchase their homes at temporarily cheaper rates in order to save money or purchase a larger home. However, this is a risky plan; if interest rates rose in the future the borrower could get caught in a loan they simply couldn’t afford.
You should always keep the worst case scenario in mind when looking at an ARM. For example, consider a 30-year, $200k loan at 5% interest with a 6% lifetime cap. By adding the lifetime cap to our interest rate, we see that our interest rate can max out at 11%. At 5%, our monthly payments would be $1073.64. If the worst happened and interest rates rose dramatically pushing our rate to 11%, our new monthly payment would be $1,885.65. It’s important to note that these are unlikely circumstances, but since they could potentially happen, being able to handle them is vital.
For most borrowers, an adjustable rate mortgage should be an option, as long as they understand how to properly use one. Don’t be lured in by the promise of lower monthly payments, and make sure the ARM will be a better bet for you over the course of the loan than a fixed rate mortgage. That entails making sure you are capable of handling the loan in the worst case scenario; if not, an ARM could lead you into foreclosure.
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