Real Estate: What is an Adjustable Rate Mortgage? ARM

What is an Adjustable Rate Mortgage (ARM)?

Real Estate Terms and Definitions:

Adjustable Rate Mortgage

Quick Definition: Interest rates are periodically adjusted up or down over the life of the loan based on a specified financial index. The plan may have rate or interest "caps" that limit the amount your interest rate may change. An ARM generally carries a lower initial rate than fixed-rate loans because it moves with the market.

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In-Depth Explanation of Adjustable Rate Mortgage

Adjustable rate mortgages have interest rates that change over time.  There are a wide range of ARM products, and they can be financially beneficial in certain situations.  The most common types of adjustable rate mortgages are 3 year, 5 year, 7 year, and 10 year ARMs.

These multi-year ARMS will have a set interest rate for the length of the initial fixed rate period.  For example, a 5 year ARM might be fixed at 3.0 percent for 5 years.  While the market rate for a 30 year fixed rate mortgage might be a higher rate like 4.5 percent, the lender offers an ARM at a lower initial rate because there is the opportunity to make more money at the end of the loan when the interest rate adjusts.

In this scenario, after 5 years of paying on the mortgage at 3.0 percent, the borrower's rate might rise to 4.0 percent in the first year.  The rate could rise again the next year to 4.5 percent.  Adjustable rate mortgages are tied to an index, which is a financial instrument that rises and falls based on the markets.  One example is the London InterBank Offer Rate (LIBOR).  This benchmark rate is what banks offer one another when lending money.  If the rate banks charge one another goes up, the LIBOR goes up, and your adjustable rate mortgage rate goes up.

To put it simply, if it gets more expensive for banks to borrow money, it's going to get more expensive for you to borrow money.  When you get past the fixed rate period of your ARM, your interest rate will be affected by how much it costs banks to lend in that current market.  Your rates, and payments, will go up when banks' costs do.

There are usually caps on ARMs.  They may specify that your rate can't go up more than 1 percent at a time, can only be adjusted once every 6 months, and can't go up more than 5 percent total during the life of the loan.  Every adjustable rate mortgage can have its own terms, so pay specific attention to the details.

Are ARMs Dangerous or Bad for Real Estate Consumers?

Adjustable rate mortgages got a bad rap during the last housing downturn.  Lots of home buyers were qualifying for 2 year ARMS in which they could only afford the first two years' payments.  When the rates adjusted upward, the payments became too high, and many of them went into default and had their homes foreclosed upon.

Like any tool, ARMs can be used wisely or foolishly.  Lax underwriting during the boom (not qualifying buyers on the future payments), lack of credit oversight (loosening of standards that had required good past payment history), and ignorance of future income prospects (no verification of employment and income) led to many ARMs turning into foreclosures.  

see more: http://blog.seattlepi.com/seattlewaterfronthomes/2015/03/10/real-estate-what-is-an-adjustable-rate-mortgage-arm/