An ARM mortgage is different from a conventional fixed-rate or adjustable-rate mortgages in that the interest rate is determined primarily by a floating-rate interest rate, rather than being tied to the current interest rates. With an ARM mortgage, the mortgage rate is adjusted periodically based on an indexed rate. This means that the ARM interest rate will change as compared to a fixed-rate interest rate, but for the most part stays the same. An ARM mortgage is ideal for borrowers who anticipate rising interest rates because the monthly payment amount will not increase over time.
Fixed-rate and adjustable-rate ARM mortgages are essentially the same thing, but refer to the difference between these two types of loans. A fixed-rate ARM follows the path of inflation. With a fixed-rate ARM, the initial interest rate is determined when the borrower purchases the home, and this interest rate is used throughout the introductory period. During the introductory period, the borrower pays no interest but is charged the applicable interest rate.
For many homeowners with good credit, an adjustable-rate mortgage makes sense. An ARM begins to adjust upward when the initial interest rate is raised, but it remains at its current level after the introductory period. This allows borrowers to lock in their interest rate at a lower rate once they have bought the home. However, there are some disadvantages associated with adjustable-rate mortgages. Borrowers who purchase homes with adjustable rates often find that their payments during periods when the mortgage is adjusted upward are higher than those payments made when the rate is initially set. These borrowers are unable to make the necessary adjustments to their mortgage to prevent the home equity value from decreasing.
When both types of mortgages are used, cap locking prevents them from being adjusted. Cap locking is the practice of locking the mortgage rate at a certain rate even after the initial mortgage has been purchased. The primary reason for this practice is to protect the lender’s investment. If the market consistently sees an increase in the number of homes that are for sale, the lenders may find themselves at a disadvantage if they do not intervene and cap their rates. Although cap locking reduces the risk for the lenders, it does not necessarily reduce competition among homebuyers. Many homeowners believe that if lenders are unable to increase the mortgage rate, the market will become saturated with homes that have already been sold at inflated prices.
Another advantage of adjustable rate mortgages is that they are rarely susceptible to interest rate changes. When rates rise, most borrowers have little to lose because their ARM mortgage payment will not increase. On the other hand, when market conditions change, homeowners are forced to react. If market conditions have improved and the prime rate is at a reasonable level, most borrowers may wish to remain with the same interest rate because they will have greater flexibility when interest rates fall.
Homeowners who are in the process of refinancing their ARM loans should also consider whether they require a longer time frame to pay off their loan. If the economy is improving and unemployment is falling, homeowners will probably be able to finance their refinance faster than in previous years. If market conditions are holding steady, however, they should consider a longer loan period to ensure that they are not paying on their house longer than necessary. Ideally, the homeowners should want to get down the length of their loan by at least five years, although the exact length of their mortgage interest-only or ten-year fixed-rate period should be dependent upon their individual circumstances.
There is also the possibility that the adjustable rate mortgages may not be a good fit for some borrowers. For example, those who buy their homes using cash may not qualify for fixed-rate mortgages. Homeowners using second mortgages might also be averse to taking out a large amount of debt in order to refinance their adjustable-rate loan into a more affordable fixed-rate loan. Homeowners whose credit profiles are already poor should also avoid adjustable rate mortgages, as they will have a harder time getting approved for a low-interest-only or interest-only mortgage when their credit ratings are low.
Finally, a borrower interested in refinancing their ARM should consider their options. In the past, homebuyers were limited to just two options: either purchasing a fixed-rate home loan or financing through an interest only mortgage. However, many lenders have recently started offering interest only ARMs, which are more flexible, with longer payment durations. These loans are especially attractive to borrowers with good credit, as they can effectively lower their monthly payments by only a small percentage of the initial mortgage.