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Understanding the Adjustable Rate Mortgage

by Brandon Cornett

The adjustable rate mortgage (or ARM) often confuses home buyers who are not familiar with them. But once you understand the basics of how and when an ARM loan adjusts, it will all make a lot more sense.

Adjustable rate mortgages are popular among home buyers who want a lower interest rate for the first few years of the loan. By "lower," I mean lower than the interest rate on a fixed-rate loan. That's the primary appeal of the ARM loan -- it usually offers a lower interest rate during the initial period.

How the ARM Loan Works

Most adjustable rate mortgages fall into the 30-year category. During the initial period of the loan, you pay a fixed interest rate. This initial period is usually 3, 5 or 7 years, but can vary based on the lender.

The interest rate during the ARM's initial fixed-rated period is usually lower than the interest rate on a regular fixed-rate loan. And of course, a lower interest rate leads to a lower overall mortgage payment each month (with all other things being equal).

When the ARM Loan Adjusts

After the initial period (3, 5, 7 or however many years), the interest rate on the ARM loan will adjust to whatever the current interest rate is at the time of adjustment. Here's the key to this -- you never know in advance what the interest rates will be 3, 5 or 7 years down the road. They might be higher, they might be lower. That's the uncertainty of an adjustable rate mortgage.

Refinancing Prior to Adjustment

The usual strategy with an ARM loan is to either refinance the loan or sell the home prior to the adjustment. That way, the home owner enjoys the lower interest rate for the initial period, but avoids the uncertainty of the adjustment period. For this reason, adjustable loans are popular among home buyers who do not plan to stay in a home more than a few years.

Other home buyers choose adjustable loans because they expect to make more money by the time the loan's interest rate adjusts. According to this logic, the home buyer will be able to afford a higher interest rate later on. But remember, a higher income is not always certain, but the interest rate will certainly adjust when the time comes.

Ask About Caps

If you're considering an adjustable rate mortgage, pay attention to the fixed-rate portion of the loan. Also ask about caps on the adjustable-rate portion of the loan. Such caps limit how high an interest rate can climb after the adjustment, but not all ARM loans come with caps.

Ask About Amortization

When considering an adjustable rate mortgage, ask your loan officer to show you the amortization schedule. These schedules show how much of your mortgage payment goes toward interest and how much goes toward the loan's principle amount.

Conclusion

This article gives you a good overview on the adjustable rate mortgage. But don't stop here. Mortgages are an important financial decision, and they require plenty of planning and forethought. Learn about the different types of mortgages from every angle. This will help you make the right financial decision.

Related article: Adjustable Rate Mortgages - The Basics

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Brandon Cornett is the Editor of Home Buying Institute.