An effective tool used by home buyers, ARM or Adjustable Rate Mortgages, offers a lower interest rate at the beginning of the loan and the risk of a hike in rates is shared by the borrower and lender.
ARM, is ideal if you are certain about rising income expectations and short-term home ownership. There are four basic aspects. One is that the initial interest rate is fixed 1-3 percentage points lower than fixed rate mortgages. Second there is what is known as adjustment interval, when after the initial period has elapsed the rate is modified in keeping with prevalent rates. Third, an index against which lenders can measure the difference between the interest earned on the loan and what would be earned in actuality in other investments. And, fourth, the component added by the lender to the index, usually 1.5-2.5 percent.
Read also: ADJUSTABLE RATE MORTGAGES AND NEGATIVE AMORTIZATION
An ARM has in addition, safeguards like interest rate caps. This limits the amount of interest rate that can be applied to the payment during adjustment. Normally this cap would be about 2% point cap over the life of the loan.
ARM is ideal when it lends you buying power. You can opt to buy a property with a higher value and still pay a lower initial monthly payment. If you know for certain that you will reside in the house you are buying for a maximum of 5-7 years then ARM is the mortgage that will save you money. If you are prepared to take risks then ARM offers the greatest possible savings especially if the rate stays steady or declines over the years.
ARM is a calculated risk as there are no certainties. However if at the end of five years your plans change and you are about to continue in the same home for another 10 years then it is prudent for you to switch from ARM to a fixed rate mortgage.
Adjustable Rate Mortgages – How they work
Many homebuyers choose adjustable rate mortgages for the initial financing on their home purchase. Rising interest rates and other terms can be confusing to the borrower.
Adjustable rate mortgages (ARMs) are loans in which the rate varies. Adjustable rate mortgages loans will follow how interest rates rise and fall. There are many reasons why a consumer might choose an ARM, but they can be risky loans.
One reason a consumer might choose an adjustable rate mortgage is the rates are generally lower in the beginning than a fixed rate loan. If you expect to be in your property for a short time, say for 5 years, then an ARM with the first 5 years fixed can be a good choice.
There are three main types of ARM loans offered by lenders. They include:
A 5/1 ARM loan is where the payment is fixed for 5 years adjusting for the remaining 25 years.
When you get a 3/1 loans payments are fixed for three years and adjust for 27 years.
The 2/1 ARM is fixed for two years and adjustable for 28 years.
An adjustable rate mortgage works like this. It is usually fixed for a certain amount of time initially, anywhere from 1 month, 5 years or something in between. After this period the loan then becomes adjustable according to the published “index”, such as LIBOR Prime rate, Cost of Funds Index, or other index plus a margin, which is the lender profit. If the index rises, your rate rises. If it lowers, your rates should fall. There is a lifetime cap on the amount interest can increase over the life of the loan.
What happens when there is a sudden higher mortgage rate?
You have some options when it comes to dealing with higher rates.
The most common is to refinance to a mixed rate mortgage. If you have enough equity built up and can afford the higher payments this is a good option. Watch out for prepayment penalties in your current mortgage. Be sure to know what the costs of refinancing are and how they will affect your loan.
Another option is the talk to a reputable credit counselor. They may be able to help you lower your payments, deferring the unpaid interest. This will increase your loan balance though. On other debts try to work out a lower payment plan to offset the higher mortgage payment. Or persuade your lender to agree to forbearance or have them postpone the increase to a future time when you will be able to pay.
You can also sell your home. List it with a real estate agent if you have the equity to pay commissions and costs of the sale. Or sell it yourself. Deed your house to the lender in a deed-in-lieu-of-foreclosure agreement. You will receive no money for your equity and your credit will be adversely affected.
Of course foreclosure is an option, but it’s not desirable. The worst thing to do is to do nothing.
When choosing an adjustable rate mortgage, be aware that rates could increase over the life of your loan. Your payments can rise and you may need to make adjustments in your other debt. If you plan on living in the home for only a short time, an ARM might be the best option in financing your new home.
Adjustable Rate Mortgages – Interest Rate Strategy
Over the last few years, many people squeezed into new homes using adjustable rate mortgages. With interest rates going up, you now need a new interest rate strategy
Adjustable rate mortgages carry a bit of a gamble for home owners. Essentially, you trade smaller interest rates and lower initial payments on the gamble rates will not increase over time. If rates stay low, you make out like a bandit. If rates increase, you need to consider your options to avoid getting stuck with a high interest rate loan and resulting cash flow problems from increased monthly mortgage payments.
For the last three or four years, adjustable rate mortgages have been offered with incredibly low interest rates. Many people used these low, low, low rates to buy homes that would otherwise be beyond their means. Starting in 2004, Federal Reserve Chairman Alan Greenspan started making noises about increasing money borrowing rates. He has followed through on these hints. Although mortgage rates aren’t tied directly to the Federal Reserve Bank, they are heavily influenced by it. As a result, many people are now facing tight finances.
Avoid Rising Rates
There are really only two solutions for avoiding the increase in interest rates on adjustable rate mortgages. The first strategy is to immediately convert to a fixed rate mortgage product. Fixed rates are still at historic lows when compared to rates offered over the last 50 years. By flipping to a fixed rate, you will be able to solidify your budget and finances since you will know exactly what you have to pay each month. If rates decrease in the future, you can always try to flip back to an adjustable mortgage loan.
Unfortunately, some home owners are simply going to have to face the fact they lost one the interest rate gamble. Typically, this will occur when you realize you simply can’t afford to make the monthly payments required by getting a fixed rate loan. In such a situation, you are going to have to sell your home and downsize. In most situations, it is better to do this now since you’ve probably built up a sizeable chunk of equity over the last few years and want to avoid a loss of that equity as the market cools down. While this may sound like a disaster, it really isn’t. Yes, you have to downsize, but you should still have built up a chunk of equity.
Interest rates are going up whether you want to acknowledge it or not. The time to deal with your adjustable rate mortgage is now, not when you straining to make payments.