- An adjustable-rate mortgage is a mortgage that has a changing rate. At the beginning of the mortgage, the interest rate is fairly close to the national interest rate and lower than the interest rate on a fixed rate mortgage. If the national interest rate goes up, so does the interest rate on the adjustable rate mortgage. On the other hand, if the national interest rate goes down, so does the interest rate on the mortgage. This makes an adjustable-rate mortgage, or ARM, a good choice when economic trends indicate that mortgage rates will be dropping.
- Often, people who are shopping for a mortgage choose an ARM because they think it is the cheapest option. This is a common misconception, because over several years an ARM can end up being quite a bit more expensive than a fixed rate mortgage. The cost of an ARM versus a fixed-rate mortgage depends on what happens to the national interest rate. Usually the interest rate will rise at some point over the life of a mortgage, and this can make the adjustable-rate mortgage much more expensive than the fixed-rate version.
- While an adjustable-rate mortgage may not always be the cheapest option, there are situations that make it a good fit. Many homeowners know that they will not be in their houses for an extended period of time. If you know that you are going to sell your home within a few years, you can benefit from the lower monthly payments on an ARM. Also, some ARMs come with a guarantee that the rate will not go up for a set number of years, and this can give you some time to enjoy a more affordable mortgage on your property.
- All adjustable-rate mortgages come with an adjustment period. This is the amount of time that will pass before your interest rate will be adjusted. This is indicated by two numbers, such as 5-1. The first number shows the number of years that will pass between the time you get the loan and your first adjustment. The second number shows how the number of years that will pass between adjustments after the initial time frame has expired.
- If you are going to choose an adjustable-rate mortgage, there are some aspects of the mortgage that you should know. First, some ARMs come with interest rate caps. These limit how much your interest rate can change, either from one adjustment period to the next or over the entire life of the mortgage. You may also have a payment cap on your mortgage. This limits how much your actual payment can increase when you have an adjustment.
- One potential risk that you face if you choose an adjustable-rate mortgage is negative amortization. This occurs when the amount you are charged each month is not enough to cover the interest you were charged that month. Because many ARMs come with payment caps, this can happen. When your interest rate increases to the point that the maximum monthly payment you are charged does not cover the interest you are charged, that interest is rolled back into the loan to incur more interest, and you start a vicious cycle that is hard to break.
