Adjustable Rate Mortgage (ARM)

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If you are buying a residential property, get a fixed rate mortgage. With the interest rates at all time historic lows, there is no reason to get an ARM. In general it can be very risky to get an ARM because most peoples incomes are fixed, so when the payment adjusts and it is higher, they can no longer afford their home.

An Adjustable Rate Mortgage (ARM) is a loan with a fixed interest rate for a specified amount of time followed by a variable rate for the remaining period. The most common types of ARMs are for 5, 7, or 10 years.

For example, a 30-year loan with a 5/1 ARM means that you’ll pay a fixed interest rate for five years, then your rate will adjust each year after that for the next 25 years. The rate changes based on an index, such as the LIBOR (London Interbank Offered Rate) or COFI (Cost of Funds Index). These indices measure the cost of borrowing money. Most lenders will charge borrowers a rate based on an index plus a margin above this rate. This margin is usually expressed as the index LIBOR + 1%, or 2%, depending on the terms of the loan. ARMs also have “caps” which means there is a maximum amount that your rate can adjust upwards during the life of the loan (ARM caps are typically somewhere around 5%).

ARMs can make financial sense if the borrower is planning to own short term, or if the borrower believes rates will be lower in the future. However, buyers should Beware of adjustable rate mortgages. Unlike fixed rate mortgages, ARM’s monthly payments can go UP- and if you can no longer afford your monthly mortgage payment when it adjusts, you will be forced into selling or foreclosure. When a borrower gets behind on their payments it can be like a slippery slope, each month getting farther and farther behind.

See also Fixed Rate Mortgage, FHA Loan, VA Loan.

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