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Adjustable Rate Mortgages: ARM's Can Be A Pain In The Neck

Jan 29, 2008
Adjustable rate mortgages, or "ARM's" are loans in which the interest rate changes periodically according to the terms of the loan program. Compared to a fixed-rate mortgage, there is usually a lower interest rate to start, but the interest rate is adjusted at periodic times, usually based upon an "index". The most common indices are the US Treasury Bills, California's 11 th District Cost of Funds (COFI), and the London Interbank Offered Rate (LIBOR). Lenders then add a set margin to that index resulting in payments, which can go up or down. ARM's normally have interest rate caps that limit how much your rate can go up or down each time it is adjusted and how much it can go up or down over the life of the loan. The initial fixed-rate period can range anywhere from one month to 7 years or more, depending upon the specific program. You want to ask what the margin, periodic cap, lifetime cap, and index will be.

Now, it may seem that an adjustable rate mortgage is a risky deal on the surface, but they can be advantageous in certain situations. ARM's are often considered by people in the process of restoring credit scores, expecting an increase in future income, or are planning to move within a set number of years. The individual takes advantage of the initial lower rate period and later sells their home or transfers to a fixed-rate loan before the rate adjusts upward. To this point, you want to know if your loan has a prepayment penalty period and the details of the penalty amount attached to your loan. A prepayment penalty occurs if you pay off your loan or refinance into another mortgage before the predetermined time period expires. For instance, suppose you take out an adjustable mortgage that is based on a 30 year repayment schedule, with your initial interest rate remaining fixed for three years. Your interest rate will begin to adjust after the initial three years, but you plan to refinance into a fixed-rate mortgage after two years. If your loan's prepayment period is set at one year, you are good to go with no penalty. If the prepayment period is set at three years or more, you will have to pay the penalty if you refinance just after the second year into the loan. Typical penalties can range anywhere from 1% to 5% of the current loan value, so you want to pay close attention to the prepayment penalty details for your mortgage. It should also be noted that some lenders waive the prepayment penalty fee if the borrower sells the home as opposed to refinancing it, and numerous states have passed laws and issued regulations that prohibit or restrict the use of prepayment penalties. Provided the prepayment period does apply to your particular mortgage, you should ask your lender under what conditions, if any, will the prepayment penalty be waived.

Adjustable rate mortgages come in many shapes and sizes. Some are advertised with very low interest rates known as "Option (Power) ARM's" or "Teaser Rates". A "Teaser Rate" is a reduced introductory interest rate designed to attract borrowers to ARM's. This initial discounted rate can be as low as 2% or even lower. The rate adjusts to the associated current market index rate plus margin after the predetermined introductory rate time period has elapsed. The introductory rate period is normally for a relative short period of a year or less. Monthly payments can virtually double after the introductory rate period has ended. These loans can create "negative-amortization" (negative equity) for the homeowner because the market-rate interest (as opposed to the "discounted" introductory rate) on the loan starts to accrue from the get-go, and monthly payments aren't enough to cover it, let alone pay down any of your principle. Hefty prepayment penalties are often associated with teaser-rate programs. Be very careful of mortgage loan advertisements quoting very low interest rates.

So you are now "armed" with more information about adjustable rate mortgages. ARM's can be a viable and beneficial loan program for many borrowers when they know the details of their mortgage and how it relates to their short term and long term plans. Just be cautious, if you don't know what you're getting into, an ARM can be a pain in the neck!
About the Author
The author is a contributing mortgage consultant with the popular Refinance Tool Box. Visit today for free information and tools provided to help you learn about mortgage refinance.
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