An adjustable rate mortgage (often referred to as an ARM) is a type of loan that offers a varying rate of interest at different times during the repayment period. These rate changes often occur on an annual basis, and depend on market conditions as to whether the rate will increase or decrease. ARMs are attractive because they usually offer lower initial rates of interest than comparable fixed rate mortages. The 5 things you need to know about adjustable rate mortgages are:

1. Know when the rate is subject to change. Some common examples of an ARM include:

  • 3/1 ARM - Rate is fixed for the first 3 years, then subject to change once per year thereafter.
  • 5/1 ARM - Rate is fixed for the first 5 years, then subject to change once per year thereafter.
  • 7/1 ARM - Rate is fixed for the first 7 years, then subject to change once per year thereafter.

2. Know what the rate increase ceiling is (if the loan even has a rate ceiling).

Typically, adjustable rate mortgages will offer a contractual maximum increase per year so the loan doesn’t get out of control. I have seen some offer around 2% for an annual rate increase ceiling (meaning if your rate was 6%, then the rate could not increase to more than 8% the next year). Many ARMs also offer a total rate ceiling, usally offered as a fixed addition, e.g.the rate cannot increase more than 6% for the life of the loan. These are very important conditions that anyone interested in an adjustable rate mortgage should look for and evaluate.

3. Have a plan for the future.

If you plan to sell the house before the adjustment period of the ARM begins, then maybe it is a viable option to consider. If you want to buy a little more house, and you think you will obtain better employment or a higher salary later, adjustable rate mortgages offer a lower initial monthly payment due to the lower initial interest rate. If you are looking to buy a house to live in for some years to come, think twice before getting an ARM; fixed rate mortgages tend to be better for this situation.

4. Ask the lender about market conditions.

Have rates been falling or increasing in the last 5 years? What does the lender think will happen over the next five to ten years? At the time of the writing of this article, rates were at 40 year lows, and are expected to increase over the next few years. Not the best time for an ARM in my opinion. If rates were substantially high, and expected to decrease in the coming years, adjustable rate mortgages would be more attractive to the borrower.

5. Review the worse possible scenario.

Using the information obtained from the lender, get an understanding how bad it could be. If the loan increased to the maximum interest allowed in the contract, how much would that cost me per month? Can I really afford it? Ask the lender as many questions as you can think of. Review the truth in lending (typically referred to as the good faith estimate) provided by the lender. Specifically, review the total interest over the life of loan, and compare to other mortgage options.

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