Adjustable-Rate Mortgage Basics

Residential Neighborhood

Adjustable-Rate Mortgage (ARM)

Adjustable-rate mortgages are those in which the interest rate is altered periodically during the life of the loan. For most ARMs, the rate is fixed initially, commonly for one, three or five years, and adjusts for the remaining years. ARMs require knowledge and attention on the part of the borrower.

Advantages

  • Monthly payments go down if interest rates fall
  • Falling interest rates reduce the overall cost of the loan
  • The starting rate charged by lenders is generally less than for FRMs, because the borrower assumes the risk of unfavorable changes in the money market

Disadvantages

  • Monthly payments may go up significantly, sometimes leading to default
  • Caps on the monthly amount to safeguard the borrower can result in payments lower than the amount due, so the outstanding balance increases every month
  • Making extra payments to principal does not shorten the term of the mortgage and is therefore less helpful than with FRMs
  • Re-financing to avoid huge hikes may incur pre-payment penalties and may be impossible if the property has insufficient equity
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