Adjustable Rate Mortgages How they work
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Adjustable Rate Mortgages: How They Work
Overview
Adjustable Rate Mortgages (ARMs) are popular among homebuyers for their initial flexibility. However, understanding rising interest rates and various terms can be challenging.
What Are Adjustable Rate Mortgages?
ARMs are loans with interest rates that change over time. They typically start with a lower interest rate compared to fixed-rate loans, making them attractive for those planning to stay in a home for a shorter period.
Why Choose an ARM?
- Initial Savings: ARMs usually offer lower initial rates, ideal if you plan to own the property for a short duration, like five years.
- Rate Types: Common ARMs include:
- 5/1 ARM: Fixed for five years, then adjusts annually.
- 3/1 ARM: Fixed for three years, then adjusts annually.
- 2/1 ARM: Fixed for two years, then adjusts annually.
How ARMs Function
Initially, ARMs have a fixed rate for a set period. After this, the rate adjusts based on a published index (e.g., LIBOR Prime rate or Cost of Funds Index) plus a margin representing lender profit. Rates can go up or down, but there is a cap on how much the interest can increase over the loan’s lifetime.
Managing Rate Increases
When rates rise, consider the following options:
1. Refinance: Shift to a fixed-rate mortgage if you have sufficient equity and can handle higher payments. Check for any prepayment penalties.
2. Credit Counseling: Consult a reputable counselor to explore options like deferring unpaid interest or restructuring other debts to balance your finances.
3. Sell Your Home: If you have enough equity, selling might be viable. You can do this through a real estate agent or on your own. Alternatively, consider a deed-in-lieu-of-foreclosure agreement, though this affects your credit and provides no equity return.
4. Avoid Foreclosure: Foreclosure should be a last resort. Taking no action can lead to severe consequences.
Conclusion
Choosing an ARM means accepting potential interest rate fluctuations. While they can be a smart short-term choice, ensure you’re prepared for possible payment increases. Always explore different options and make informed decisions about your mortgage strategy.
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