Adjustable-Rate Loans
With an adjustable-rate mortgage (ARM), the interest rate you pay is adjusted from time to time to keep it in line with changing market rates. This means that when interest rates go up, your monthly mortgage payments may go up as well. On the other hand, when interest rates go down, your monthly mortgage payments may also go down.
ARMs are attractive because they may initially offer a lower interest rate than fixed-rate mortgages. Since the monthly payments on an ARM start out lower than those of a fixed-rate mortgage of the same amount, you can qualify for a larger loan. The chief drawback, of course, is that your monthly payments may increase when interest rates go up.
You may want to consider an ARM if you are confident your income will rise enough in the coming years to comfortably handle any increase in payments. You may also want to consider an ARM if you plan to move in a few years and therefore are not so concerned about possible interest rate increases. You may also want to consider an ARM if you need a lower initial rate to afford to buy the home you want.
How much your payments can increase will depend on the terms of your mortgage. Before applying for an ARM, be sure you know how high your monthly payments could go -- the so-called "worst-case scenario." An ARM has two "caps" or limits on how large an interest rate increase is permitted: One cap sets the most that your interest rate can go up during each adjustment period and the other cap sets the maximum total amount of all interest adjustments over the life of the loan.
A typical ARM that adjusts annually, for example, may cap the yearly interest rate increases at 2 percent, meaning that the adjusted interest rate can never be more than 2 percent higher than the previous year. And such an ARM may have a lifetime rate cap of 6 percent, meaning that the highest adjusted interest rate you can ever be required to pay is no more than 6 percent above the original rate. So, if you are looking at an ARM with a current introductory rate of 5 percent, a lifetime cap of 6 percent tells you that the highest interest rate you could ever pay would be 11 percent. Only you can determine if you would feel comfortable paying this interest rate sometime in the future.
Some ARMs offer a conversion feature, which allows you to convert from an adjustable-rate to a fixed-rate loan at only certain times during the life of your loan. Ask your lender about this feature when researching ARMs.
One important thing to know when comparing ARMs is that the interest rate changes on an ARM are always tied to a financial index. A financial index is a published number or percentage, such as the average interest rate or yield on Treasury bills.
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