What Is an Adjustable-Rate Mortgage?

One of the most popular types of home loans in the market is the adjustable-rate mortgage. Adjustable-rate mortgages have a number of unique features that deserve consideration from many home buyers. Here are the basics of the adjustable-rate mortgage to help you determine whether it would be a good product for you to use.

Adjustable-Rate Mortgage

The adjustable-rate mortgage is a product that allows the interest rate on the loan to move up and down from one year to the next. This type of mortgage shifts some of the interest rate risk that is a problem for lenders over to the borrower.

Adjustment Period 

The adjustment period is an amount of time that takes place at the beginning of the adjustable-rate mortgage. During this time, the interest rate is going to be fixed, and you will have the same monthly payment. For example, when you see a product called a 5/1 ARM, this means that your interest rate is going to be fixed for the first five years of the loan. After that, the loan will be reevaluated, and the interest rate and the payment will change.

Financial Index

In order to determine how much the interest rate will change, your rate will be tied to a particular financial index. For example, it might be tied to the 1-year constant maturity Treasury, or CMT. This is a common index for gauging the movement in the market over the course of a year. At the end of the year, your lender is going to look at the financial index and determine how much it moved. As a result of this movement, your interest rate on the loan is going to fluctuate as well. This could result in a payment increase or a payment decrease, depending on which way the index moved.

Caps

Luckily for homeowners, there are usually interest rate caps involved. This means that there is a maximum that the interest rate can move over the course of a year or over the life of the loan. For example, the interest rate might be allowed to increase by only a maximum of 3 percent per year. Over the life of the loan, the interest rate might be allowed to increase by only a total of 5 percent. This acts as a measure of protection for you throughout the loan.

Negative Amortization

Some adjustable-rate mortgages will allow you to make payments that are lower than the amount of interest that you owe on the loan each month. When this happens, the amount of interest that is not paid will be added onto the balance of the loan. This is essentially making your loan bigger every single month. Typically, the lender will have a maximum amount that the loan balance is allowed to reach before you have to start making full payments. Negative amortization can be very dangerous for the uneducated borrower, and you should try to make full payments as often as you can. 



When is an adjustable rate mortgage better than a fixed rate?



When looking at both an adjustable-rate mortgage and fixed-rate loans, you may be having trouble deciding which one is better for your situation. If the interest rate that is being offered on an adjustable-rate mortgage is much lower than what lenders are offering for fixed-rate loans, it may make sense to go ahead with the adjustable rate. This is especially true if you are planning on being in a house for only a short time. For example, if you can get an adjustable-rate mortgage with five years of fixed interest at the beginning, it can help you save money. 

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