December 30th, 2018 12:25 PM by Jackie A. Graves
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Adjustable rate mortgages (ARMs) can save borrowers a lot of
money in interest rates over the short to medium term. But if you are holding
one when it’s time for the interest rate to reset, you may face a much higher
monthly mortgage bill. That’s fine if you can afford it, but if you are like
the vast majority of Americans, an increase in the amount you pay each month is
likely to be hard to swallow.
Consider this: The resetting of adjustable rate mortgages during the financial
crisis explains why, in part, so many people were forced into foreclosure or
had to sell their home in short sales. After the housing meltdown, many
financial planners placed adjustable rate mortgages in the risky category.
While the ARM has gotten a bum rap, it’s not a bad mortgage product,
provided borrowers know what they are getting into and what happens when an
adjustable rate mortgage resets.
to get a grasp on what is in store for you with an adjustable rate mortgage,
you first have to understand how the product works. (See also: Mortgages:
Fixed Rate vs. Adjustable Rate.) With an ARM, borrowers
lock in an interest rate, usually a low one, for a set period of
time. When that time frame ends, the mortgage interest rate resets to
whatever the prevailing interest rate is. The initial period in which the rate
doesn't change ranges anywhere from six months to ten years, according to the
Federal Home Loan Mortgage Corporation, or Freddie Mac. For
some ARM products, the interest rate a borrower pays (and the amount of the
monthly payment) can increase substantially later on in the loan.
Because of the initial low interest rate it can be attractive to borrowers,
particularly those who don’t plan to stay in their homes for too long or who
are knowledgeable enough to refinance if interest rates go up. In recent years,
with interest rates hovering at record lows, borrowers who had an adjustable
rate mortgage reset or adjusted didn’t see too big a jump in their monthly
payments. But that could change depending on how much and how quickly the
Federal Reserve raises its benchmark rate.
to determine whether an ARM is a good fit, borrowers have to understand
some basics about these loans. In essence the adjustment period is the period
between interest rate changes. Take, for instance, an adjustable rate mortgage
that has an adjustment period of one year. The mortgage product would be called
a 1-year ARM, and the interest rate – and thus the monthly mortgage
payment – would change once every year. If the adjustment period is three
years, it is called a 3-year ARM, and the rate would change every three years.
There are also some hybrid products like the 5/1 year ARM, which gives you a
fixed rate for the first five years, after which the interest rate adjusts once
addition to knowing how often your ARM will adjust, borrowers have to
understand the basis for the change in the interest rate. Lenders base ARM
rates on various indexes, with the most common being the one-year
constant-maturity Treasury securities, the Cost of Funds Index and the London
Interbank Offered Rate, or LIBOR. Before taking out an ARM, make sure to ask
the lender which index will be used and examine how it has fluctuated in
the biggest risks ARM borrowers face when their loan adjusts is payment
shock when the monthly mortgage payment rises substantially because of the
rate adjustment. This can cause hardship on the borrower's part if he or she
can’t afford to make the new payment.
prevent sticker shock from happening to you, be sure to stay on top of interest
rates as your adjustment period approaches. According to the Consumer Finance
Protection Board, mortgage servicers are required to send you an estimate of
your new payment. If the ARM is resetting for the first time, that estimate
should be sent to you seven to eight months before the adjustment. If the loan
has adjusted before, you’ll be notified two to four months ahead of time.
more, with the first notification lenders must provide options that you
can explore if you can’t afford the new rate, as well as information about how
to contact a HUD-approved housing counselor. Knowing ahead of time what the new
payment is going to be will give you time to budget for it, shop around for a
better loan or get help figuring out what your options are.
an adjustable rate mortgage doesn’t have to be a risky endeavor, as long as you
understand what happens when your mortgage interest rate resets. Unlike fixed
mortgages where you pay the same interest rate over the life of the loan, with
an ARM the interest rate will change after a period of time, and in some cases
it may rise significantly. Knowing ahead of time how much more you’ll owe
– or may owe – each month can prevent sticker shock. More important, it can
help insure that you make your mortgage payment each month.
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