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Pros and Cons of ARMs

The adjustable-rate mortgage is a loan that has the interest rate vary after the fixed term is completed. That means the monthly payments are subject to change. They may go up or down depending on several factors like index and margins set by lenders. Even though the mortgages vary because of the structure of the fixed term and the number of times the interest rate resets, the interest rate for the ARM is static for the initial duration. The ability to refinance after the initial term is what primarily makes them attractive.  If a customer is considering buying their home for only a few years or they are expecting the income to appreciate in the future, the ARM could be a good alternative. This is the case if the fixed interest mortgage rate proves to be very expensive.

Margin

Margins refer to the percentage added to the index, which determines the new interest rate. They are usually between 2 and 4 percent. The index plus margin is technically known as the fully indexed rate though most would call it the interest rate. The margins are added, so the lender can make a profit because indexes used a lot have meager rates. The size of the margin may also be dependent on credit. For example, the better the credit report the borrower has, the smaller the margin applied, and that means a lower premium paid every month. Though it is essential to note the one with the most significant margin does not have to be the one losing. Some mortgages use the cost of funds index, which is less volatile. Others utilize the LIBOR, and this one is a bit more reactive.

Interest Rate Index

The index rate index is what affects the adjustment. The index is a general indicator for the current interest rates as the rate on the Treasury bonds or the rate which the banks may pay on the deposits. Should the rates increase, then the index is going to decrease. When the interest rates go down, then the index is also going to reduce. On the other hand, each of the indexes is going to follow the trend which may not track the current interest ratings.

Pros of Adjustable-Rate Mortgages

Increased Flexibility

If one is in a position where they know their life is going to change in the next few years, then the adjustable-rate mortgage is the way to go. Perhaps the borrower knows they are going to make a career change and have to move so they will sell the house. A projected windfall like trust fund opening up is another scenario or a contract end. In these situations, the borrower can take advantage of the foresight and the fixed-rate period before they sell the property as the adjustable period begins.

Caps Available for ARMs

It is possible to negotiate caps for the adjustable-rate mortgage contract to limit the liabilities the borrower faces during a period of adjustment. The caps tend to be popular, considering they restrict how the rate changes every time there is an adjustment. An interest rate cap may also be included within the contract at each instance. There are payment caps as well, and they limit how much the mortgage grows during each period of adjustment. Each of the caps provides particular benefits and risks.

Mortgage Payments Become Smaller

Much of the discussion on the adjustable-rate mortgages is concerning what happens should the economy become bad, and the rates rise. That indicates the premiums paid every month are also going to increase significantly. The opposite is also possible if the economy is in the right place. During booms, investors in the economy create a sense of stability, which allows the rates to decrease. The monthly premiums which depend on these rates significantly decrease after that, and so the borrower could end up paying less for the loans over the term.

Payments During the Fixed-Rate Period are Small

Several fixed-rate ARMs, including the hybrid mortgages, provide the buyers with a period where there are fixed rates every month. The rates during this time, depending on the mortgage seller are typically low. They could be lower than a long term fixed-rate mortgage of 15 or 30 years. The introductory period allows for friendly rates and predictability for the borrower, especially if they do not have a very steady income.

Cons of Adjustable-Rate Mortgages

They are Complex Products for Lending

The ARMs are a bit more complex as mortgages compared to the traditional fixed-rate mortgages. They abide by flexible rules, and this could confuse several in the market, so they place themselves in tough situations. A good example is what happened with the global financial crisis. Several in the market did not understand the nature of their mortgages and ended up in foreclosures. The actual structure of the mortgage may create a significant risk for buyers who do not understand the nature of the market and what will be required of them.

Possibility for a Prepayment Penalty

A few adjustable-rate mortgages come with pre-payment penalties as part of their contracts. That would mean it is possible to be charged particular fees if selling or refinancing on loan within a specific time. As a rule of thumb, should the borrower want to sell their home within the first five years they move into it, it would be advisable to clear it with the lender without removing any of the prepayment stipulations. This is so there are no large penalties.

Payments can be Bigger

The advantage of ARMs is the chance the economic stability can boost the payments such that the borrower only has to issue a small payment every month as premium. The converse can also happen as it did in 2008. Suddenly the market collapsed, and people started paying 200 to 300 percent more on their monthly payments leading to mass foreclosures.