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Advantages and Disadvantages of Adjustable Rate Mortgages

Oct 13, 2007
When consumers begin shopping for a home loan they are often presented with the option of using an adjustable rate mortgage. An adjustable rate mortgage (also known as an ARM) can be a great way to buy a home but it can also be a horrible mistake that can lead to foreclosure or even bankruptcy. The difference between joy and disaster is often in the mortgage contract itself.

When consumers hear the term "adjustable rate mortgage" they should understand that this is a very broad term indeed, and that it can mean many things. There are, literally, dozens of varieties of ARM's available to home shoppers, and knowing the good ones from the bad ones should be a home buyer's first concern.

In general, an adjustable rate mortgage begins with a set rate of interest for a specific length of time. This first rate is usually lower than what consumers can find in the fixed rate market at the same time. This lower rate is the inducement to take the ARM over the fixed rate products.

At some point in time, and this will be spelled out in the contract, the lower rate will be adjusted. The adjustment can go up or down, but normally goes up, as you might expect. The factors that determine how much the rate goes up (or down) are many and vary from one lender to another. They also vary depending on the level of the mortgage. In other words, an adjustable rate mortgage that is also considered a sub-prime loan may have a huge increase in rate (along with increases in fees and service charges) which can make the new monthly payment difficult to pay.

Prime loans, on the other hand, which are more traditional in nature and are considered less risky by lenders, usually have caps on the amount of increase that is allowable for any one increase. This helps home owners (at least to some degree) to better understand what the max payment might be for their home at any given time in the future. In a very real sense it voids the "sky is the limit" possibility.

The only way to know if a particular adjustable rate mortgage is right for you and your budget is to sit down and read the contract slowly and carefully. You may notice some odd-looking numbers such as 1/3, 2/7, or 1/10. The actual numbers you see may vary according to the contract you are looking at, but, in essence, they mean that the introductory interest rate will last for the first number in the term. In the case of 1/3, that means that for one year you pay the lower interest rate and an adjustment takes places and will continue to take place every three years afterward. A 2/7 would mean you get the first rate for two years, then an adjustment takes place and another adjustment will take place every seven years after.

An adjustable rate mortgage can be confusing even for the most intelligent of people. If you have any questions about the contract you should ask the lender or an attorney that you trust. The time to have these questions cleared up is before you sign the contract.
About the Author
Peter Kenny is a writer for The Thrifty Scot, please visit us at Cheap Mortgages and Remortgages
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