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Understanding adjustable rate mortgages

The two most popular types of mortgages available to consumers are fixed-rate mortgages and adjustable-rate mortgages.

There are many differences between these two types of mortgages as well as various advantages and disadvantages for both of them. The important part of it is understanding what type of mortgage is best for your personal situation. This article will focus on adjustable rate mortgages.

The article, “Adjustable rate mortgages,” featured on Bankrate.com, gives a good overview on adjustable rate mortgages or ARMs, and the pros and cons to each.

There are many differences between a fixed rate mortgage and an ARM. The most influential characteristics that set the two apart are that ARM’s rates adjust with the rise and fall of interest rates, while a fixed rate mortgage stays at the same rate for the duration of the loan.

“Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as market interest rates fluctuate. Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.”

Fixed rate mortgages interest rates never change, so this can be very appealing to people who are worried about interest rates rising too high.

One of the advantages to an ARM is that the interest rates start out very low, and this can be something that is very attractive to a number of people.

“Rates charged during the initial periods are generally lower than those on comparable fixed-rate mortgages. After all, lenders have to offer something to make it worth their while to assume the risk of higher rates in the future.”

“The initial fixed-rate period can be as short as a month or as long as 10 years. One-year ARMs, which have their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid. Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.”

These hybrid ARMs have fixed rates for a certain number of years (three, seven or 10) for example, and then convert to adjustable rate after the appropriate amount of time has expired.

ARM’s rates depend on a couple of major indexes to determine what the interest rates are going to be.

“After the fixed-rate honeymoon, an ARM's rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure and recalculates the borrower's new rate and payment. The process repeats each time an adjustment date rolls around.”

The three major indexes are the weekly constant maturity yield on the one-year Treasury Bill, the 11th District Cost of Funds Index (COFI) and London Interbank Offered Rate (LIBOR).

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