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Understanding Adjustable Rate Mortgages

An adjustable rate mortgage is exactly what the name implies; a home mortgage loan with an interest rate that gets adjusted during the life of the loan...

Adjustable rate mortgages gained popularity in the high interest loan market of the 1980's.  With rates as high as 16% quoted for even those with high credit scores, obtaining a mortgage loan with affordable monthly payments became difficult.  At that time, ARM's provided rates that began far below the market rates and homebuyers planned to replace the adjustable with fixed rate loans when the economy improved.   It was a great option for many buyers and worked extremely well.  Those loans did adjust but the better lenders had tight caps on how much the interest rate could rise per year and often there was a two year period before a new loan adjusted at all.

Lenders usually associate two numbers with these loans.  You may see 5:1, 1:1 or 3:2.  The first number is the number of years the ARM will stay at the initial interest rate before reaching its first adjustment period.  The second number is the length of time between adjustments after the first occurs.

A 5:1 indicates the original rate is guaranteed for the first five years of the loan.  the 1 means the rate will be reviewed and perhaps adjusted yearly after that initial five year period.

The most common combination some years ago was 1:1 or 2:1.  In recent years, the 5:1 option has attracted buyers and for some loans adjustments after the beginning rate time period may be made every 6 months.   This second type carries much higher risk for the borrower over the long term.  It was used primarily by those who planned to live in the home for only a few years.  Unfortunately, the collapsing housing market resulted in a glut of homes for sale and some homeowners are facing huge increases in monthly payments because they are unable to sell their property.

Before choosing an adjustable rate mortgage, it is important to understand that they have both advantages and disadvantages and the choice of which type of mortgage is best for you will be largely determined by the current market as well as your own situation.

The advantage of ARM's is the ability of the lender to offer a lower percentage and it may still be a good option for those who buy for the short term - but only if they live in an area not highly affected by the eroding market.  As long as the buyer has the credit rating and ability to obtain a better mortgage if needed, it's a useful buying tool.  In a period of high rates, these loans are practical options.

The disadvantage is, of course, the risk involved for the home buyer.  The success of the purchase depends on the financial market volatility, whether interest goes up or down, home valuation, etc.  Those averse to risk are advised not to consider an adjustable rate mortgage under any conditions.