The best way to explain adjustable rate mortgages (ARMs) is to compare them to a fixed rate mortgage – with a fixed rate mortgage you will have a fixed interest rate and therefore a fixed monthly mortgage payment throughout the life of your loan. However, an adjustable rate mortgage will typically see your interest rate and monthly mortgage payment fluctuate whenever market interest rates change. With that being said, the vast majority of ARMs will offer an initial fixed interest rate before being followed by a much longer variable rate.
Why Choose an Adjustable Rate Mortgage?
It may not make a lot of sense to have a mortgage product that sees both your interest rate and monthly payment change throughout the life of the mortgage, but there are certain advantages. Admittedly, if you are on a tight budget and if your income is likely to stay much the same throughout the life of your mortgage, then a fixed rate may be better for you. With that being said, an ARM will usually offer a lower initial rate when compared to a fixed rate mortgage and this is basically because there has to be something worthwhile when considering the potential risk of interest rates increasing in the future.
An ARM may also be a far better option if the economy dictates that interest rates are likely to drop quite considerably at some point in the future. With a fixed rate mortgage you will unfortunately not be able to take advantage of decreasing interest rates, as you have a set (fixed) amount to pay, irrespective of outside influences. However, decreasing interest rates may see your mortgage payments drop again and again if you have taken out an adjustable rate mortgage.
How ARMs Work
As mentioned, you may have an initial fixed rate with an adjustable rate mortgage and this could be as short as a month or two or even as long a period as 10 years. One of the most popular ARMs for many years involved having a fixed rate period for a year and then converting to a variable rate thereafter. However, in recent years the 5/1 is proving to be the most popular ARM product, which will see a homeowner have a fixed rate period for 5 years before converting to a variable rate.
If the truth be told, there are many hybrids to the ARM, including 3/1, 5/1, 7/1 and 10/1, which will see initial fixed rates for three, five, seven and ten years respectively. After this initial fixed rate period of time your interest rate will fluctuate in accordance with the rate index spelled out in your mortgage documentation. The vast majority of ARMs will follow one of three indexes, which are the Maturity Yield offered on the Treasury Bill, the 11th District Costs of Funds Index (COFI) and the London Interbank Offered Rate (LIBOR).
This can, of course, become very confusing and this is why many people turn to the help of a mortgage broker to ascertain which type of mortgage product is best for them. There are a number of other important aspects of both fixed rate mortgages and ARMs you should be aware of and therefore it may be beneficial to draw on expert help.
This post has been contributed by Nancy Baker, who is a freelance blogger who is currently working for a firm that offers commercial mortgage solutions in Toronto. She is passionate about cooking and she enjoys gardening as well.
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