Adjustable Rate Mortgages

May 4, 2009

Adjustable rate mortgages may not be as popular as they were only a few short years ago but they can still be beneficial if you only need to borrow money for real estate for a relatively short time period.  Here’s a look at what adjustable rate mortgages are and who they can benefit.

Adjustable Rate Mortgages

The adjustable rate mortgage does exactly what its name implies. It adjusts the interest rate of the mortgage during the life of the loan. Many adjustable rate mortgages have a fixed rate period of 1, 3, 5, or 7 years, and then the interest rate adjusts to a specified rate index

These loans are often referred to using the format, a 3/1 or 5/1 ARM. This means that the interest rate is fixed for 3 or 5 years, and then it adjusts to an index rate, such as LIBOR, plus some margin amount added on by the lender.

During the fixed period, the loan acts like a fixed rate mortgage. It charges the initial interest rate agreed to in the mortgage note. Once the fixed rate period is over, the interest rate and the monthly payments due are re-calculated based on the index rate.

Most adjustable rate mortgages have caps in place which limit the scope of the potential rate changes.  These caps typically determine how often the interest rate for the mortgage is allowed to change and maximum amounts that the interest rate is allowed to reach over time.  For example, the caps may say that interest rate can only be adjusted every six months and can’t be adjusted by more than 1% a year.

Adjustable Rate Benefits

Although interest rates are historically low right now, in times when rates are higher, adjustable rate mortgages can offer advantages for shorter term loans. When rates are higher the introductory interest rate on ARMs are significantly lower than they would be on a fixed rate loan. For investors or consumers who only plan on owning a piece of real estate for a several year time frame an adjustable rate mortgage allows them to pay lower interest rates.

For example, if you move to a new town and know you’ll be moving back in few years there is no need to borrow the money to buy a home for a 30 year term.  Lenders charge more for 30 year loans to compensate for the additional risk they take on by lending you money for a longer term.

If you only need the money for a shorter time period, you can pay less in interest if you borrow it for a shorter period with an adjustable rate mortgage.

Adjustable Rate Cautions

During the 1990’s and early 2000’s, adjustable rate mortgages became popular for buyers with less than perfect credit or little capital. The lower inital interest rate was used as a means to help buyers qualify for more house than their income could support long term. 

Of course we’ve all seen what happened to the housing market and the economy when too many people tried to borrow more than they could afford. An adjustable rate mortgage can be a useful tool for lowering your interest payments if you’ll only own real estate for a short period of years.  However, if you use it simply to get lower initial monthly payments on a piece of property that you couldn’t afford at higher interest rates, the adjustable rate mortgage probably isn’t the best financing option for you.

 

Ben

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Ben

Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn’t like the other kids… His addiction to personal finance has paid off for his family and now he’s helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.


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