An ARM is a loan that offers you a short introductory period with a low, fixed interest rate. After that period—usually two to five years, sometimes more—your rate becomes adjustable, up to a certain limit.
Adjustable-rate mortgages are certainly tempting, with their low introductory interest rates, but we’ve all seen their downside in the recent housing crisis.
But adjustable rate mortgages, or ARMs, aren’t all bad; in fact, they can work well for many homeowners.
The secret is in understanding the potential problems and pitfalls before you sign up.
Adjustable-Rate Mortgage Basics
After the introductory period ends, ARMs become a bit of a gamble.
If interest rates stay the same or increase, your interest rate will jump up after the intro period ends.
If interest rates go down, it is possible your payments might stay the same or even go down.
Potential Problems With an Adjustable-Rate Mortgage
Many homeowners are able to work ARMs to their advantage, but there are still potential problems you should understand before committing:
- Rates will probably increase after the fixed intro period is over, and the increase can be sharp and dramatic.
- Gradually, your interest rate can go as high as the lifetime cap.
- Many new homeowners assume their financial situation will improve before the increase happens. This can create financial strain if things don’t go according to plan.
- Often, lenders offer an “interest-only” option. This lessens your payment to just interest, no principal. It is only allowed for a limited time period (usually five or ten years), and then the payment increases to allow you to pay off the home. This payment increase can catch some people off guard.
- Many ARMs have a prepayment penalty attached, meaning you cannot pay off your loan in full for the number of years specified in your agreement. If interest rates jump while you still have a prepayment penalty in place, you cannot refinance or sell your home without a huge cost.
How to Approach an Adjustable-Rate Mortgage
When you get an ARM, the loan is much trickier to understand than a fixed-rate mortgage. Lenders and mortgage brokers are legally required to give you supporting literature if they put you in an ARM. This is so you can be well-informed about your loan.
However, most people do not read through the brochures they are given—and therefore do not understand how their loan works. Make sure you read everything your lender gives you before you sign. Ask questions if there is anything you do not understand.
One of the reasons people get into trouble with an ARM is they haven’t planned ahead for the adjustments in payments. When you qualify for the loan, you are not qualified for monthly payments on the cap (i.e., the most the interest can increase), but rather the current interest rates. You must be prepared for the payments to go up if the rates go up.
The first step is to know what that payment could be. Sit down before you sign the loan documents and calculate what that payment could be. If you know you could never make that payment, don’t get the loan. It is too big a gamble.
Refinancing before the loan adjusts to a higher payment is often the best solution, if you have the ability. However, you need to read through the paperwork and know the conditions of the new loan. Don’t jump from one bad loan to another.
Original Article From: www.Realtor.com | Written By: Angela Colley
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