By Jeff Miles on January 23, 2010
Adjustable rate mortgages have received much negative attention recently with the U.S. housing crisis. But what exactly is an adjustable rate mortgage (ARM)? And are all ARMs bad?
Let’s start with the first question. The Federal Reserve defines an ARM as “a loan with an interest rate that changes.” This means that your payment can change every month, quarter, year, three years, or five years. The interest rates on ARMs usually fluctuate according to an index.
An index is essentially a measure of interest rates generally. Lenders use a variety of indexes; two of the most common are the Cost of Funds Index (COFI) and the London Interbank Offered Rate (LIBOR). In addition to the index, an individual lender usually adds a little more on top. This amount is called a margin. When comparing different ARMs against each other or an ARM against a fixed-rate mortgage, it’s important that you be aware of indexes and margins and ask your lender about their specific policies.
People usually find these loans attractive because they usually have a fairly low monthly payment for the first couple of months or because they think that there is a strong possibility of their monthly payment decreasing.
So back to the second question: are these loans the villains that the popular press has made them out to be in recent months? The answer is yes and no. ARMs aren’t so bad for two reasons. First, the lower initial interest rates tend to make them cheaper than fixed-rate mortgages for at least the first few months. Second, ARMs can actually end up being cheaper in the long run if interest rates stay stable or drop.
ARMs are dangerous for a variety of reasons though. First, your monthly payments could go up even if interest rates don’t. On that same note, if interest rates go down that doesn’t guarantee that your payments will go down proportionally or at all. Additionally, if you decide you would like to pay off your loan early, you may pay a penalty.
So, at the end of the day ARMs are like a lot of other things in the financial world. They can be good tools if you completely understand everything they entail and you are prepared to take some risk, but you should take caution when using them. |