Adjustable rate mortgages (ARMs) have been a popular form of mortgage financing in recent years. These mortgages start out at low rates for a set period; then adjust along with the index to which they are tied. As interest rates go up, so do the monthly payments.
With fixed rate mortgage financing, the interest rate stays the same over the life of the loan. But with an ARM, the rate can increase at regular intervals up to the ceiling set by the mortgage. The adjustment period between one rate change and the next is either one year, three years, or five years.
The index to which the interest rate is tied varies from lender to lender. The most common indexes are the rates on one, three, or five-year Treasury securities. Another favorite is the average cost of funds to savings and loan associations. To the index rate, the lender adds a few percentage points called the “margin.”
The main attraction
The main attraction of adjustable rate mortgage financing is that it is initially cheaper than fixed rate financing for the same size mortgage. Not only does this mean lower monthly payments to start with, it means borrowers can qualify for larger loan amounts. That’s because lenders sometimes decide whether to make a mortgage based on the ratio of current income to monthly payment.
Some lenders also offer what is known as option ARMs. These give borrowers several payment choices each month, including a minimum payment set once a year, an interest-only payment, and what would be the standard payment on a 15-year or 30-year mortgage.
The main drawback
The trade-off for low initial rates is the risk of rates going higher in the future—much higher. Many borrowers who run into this problem are having to refinance, as Frank Nothaft, Freddie Mac’s chief economist points out. “But the wide proliferation of adjustable-rate mortgages originated in the past few years that are nearing their first interest-rate adjustment provides borrowers an incentive to refinance into a lower-cost ARM or fixed-rate mortgage.”
At least $1.1 trillion in adjustable-rate loans are due to reset in 2007 unless they are refinanced, according to research conducted by the Mortgage Bankers Association. Many of the loans are indexed to short-term rates tied to the Federal Reserve's federal funds target, which has climbed to 5.25 percent from 1 percent in early 2004.
Right for you?
Adjustable rate mortgage financing make sense for borrowers,
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