August 3rd, 2018 7:56 PM by Jackie A. Graves, President
When it comes time to take out a mortgage on a property,
there are many different types of loans available. From government-backed VA
and FHA loans, to conventional fixed-rate 15-, 20-, or 30-year loans, there are
lots of options to consider. One avenue you may not have considered — and
may have even been warned against — however, is an adjustable rate mortgage, or
mortgages got something of a bad rap during the housing market crash of 2007
and brought many banks’ lending practices under the microscope of scrutiny.
During that time, lenders would often use ARMs, which carry lower initial
interest rates, in order to get borrowers’ payments where they need to be in
order to qualify for loans. The catch? When the interest rate would adjust,
borrowers would be stuck with a higher interest rate and, in many cases, a
higher payment they simply couldn’t afford.
An adjustable-rate mortgage (ARM) is not a
long-term, fixed-rate mortgage. Instead, it offers borrowers a lower initial
interest rate for a shorter fixed period of time — usually three, five, or
seven years. While the principal and interest payment on the loan is still
calculated over 30 years, the interest rate changes based on several factors
once that three-, five-, or seven-year time period is up. Those factors
rate indexes – ARMs are tied to an index
of interest rates such as the London Interbank Offered Rate, also known as
Libor. Libor is one of the benchmark rate indexes used by leading banks to
dictate what they’ll charge each other for short-term loans.
– The loan margin is established when the loan is initially
approved and remains fixed for its entirety. The margin is a fixed percentage
that is added to a loan index rate to obtain the fully indexed rate for an ARM.
For example, if your index rate is three percent and your margin is three
percent, your fully indexed interest rate would be 6 percent. Margins can
sometimes be negotiated with the mortgage lender.
caps – ARMs typically have a cap that defines a
maximum interest rate and a periodic cap limiting the amount the interest rate
can change within a single adjustment period.
As the general public has become more
informed about ARM loans and their potential benefits and pitfalls, more
borrowers are opting for these types of mortgages when it makes sense. Let’s
take a look at four of the reasons more borrowers these days are opting for
When interest rates are already low, ARMs
are less popular among borrowers. But because interest rates on ARM loans are
always lower than on conventional fixed-rate loans — generally by about .5
percent — they’re particularly appealing at times when conventional interest
rates are high. During these times borrowers are often willing to risk a higher
future rate in exchange for lower payments now.
Some homebuyers choose ARMs because they
know they will not keep the loan long enough for the introductory rate to
expire. Therefore, they know they can avoid the interest-rate adjustment. For
this reason, ARMs can be a sound option for those buying investment properties
or fixer-uppers that they intend to hold onto for only a few years. The most
popular ARM loans carry fixed-rate terms of five or seven years, which gives
most investors plenty of time to get in and out of the property, and make the
lowest possible payments in the meantime.
One word of caution here: It’s important to
make sure that you are aware of any prepayment penalties associated with the
loan. For example, some loans carry a penalty of 2 or 3 percent if they are
paid off early. Refinancing a loan or selling the property both result in the
original loan being paid off and that penalty can be assessed in these cases if
the prepayment period has not yet expired. This can end up costing an unwitting
homeowner a significant chunk of change. Therefore, be sure to ask your lender
about prepayment penalty details if you plan to refinance your way to a lower
payment after the initial low-interest period expires, or to sell the property
While ARMs are less appealing to some borrowers, they’re also less
appealing to would-be identity thefts and criminals, according to recent data. First
American, which provides mortgage and title services, said earlier
this year that there is now less fraud risk associated with adjustable-rate
mortgage applications than with conventional loans.
“ARMs historically have had more defect, fraud and misrepresentation risk
than the traditional 30-year, fixed rate mortgage,” said Mark Fleming, chief
economist at First American. “Interestingly, that has changed recently. ARMs,
based on our defect,
fraud and misrepresentation index, are modestly less risky.”
Borrowers with credit
scores that dip below 680 are less likely to qualify for
conventional loans and therefore will end up paying higher interest rates.
Higher interest means higher monthly payments. Borrowers and their lenders
often circumvent this problem with an ARM loan. The lower associated interest
rate can make a big difference in a borrower’s ability to qualify for a
mortgage loan and to make the monthly loan payment.
If you are interested in an adjustable-rate mortgage for these or other
reasons, it’s important to weigh all of the pros and cons with your mortgage
lender to ultimately determine if an ARM is right for you. If you believe your
credit score may prevent you from qualifying for a conventional loan with a low
interest rate, it’s a good idea to do a free check of your credit score before
applying for a mortgage loan. Doing so can save you money in the long run.
If you’re curious about your credit, you can check your three
credit reports for free once a year. To track your credit more
free Credit Report Card is an easy-to-understand breakdown of your
credit report information that uses letter grades—plus you get two free credit
scores updated every 14 days.
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