Adjustable rate mortgages or ARMS are one of the most controversial financial products ever created. Some observers even blamed ARMS for the mortgage meltdown and financial crisis of 2007-2008. The critics complained that many homeowners ended up in foreclosure because they could not pay off such a mortgage.
Many of those foreclosures could have been avoided if the homeowners had understood what adjustable rate mortgages are and how they work. Everybody who is thinking about getting a mortgage needs to be aware of how an ARM works.
How an ARM Differs from a Traditional Mortgage
In a traditional fixed-rate mortgage such as a 30-year mortgage the homeowner pays the same interest rate for the length of the loan. The interest rate stays the same so the payments will stay roughly the same.
The interest rate on a fixed-rate mortgage is determined by the prime rate (what lenders pay for money) and the amount of risk the lender takes. If the prime rate is 3% when a mortgage is issued the interest rate will be around 4% to 5% on the average mortgage.
In an Adjustable Rate Mortgage the lender has the right to adjust the interest rate at some point. A common arrangement is that it can adjust the rate to match the prime rate in the future. If the primate rate rose the interest and the amount of the mortgage payments would rise. If it fell the lender could lower the rate and the payments.
Initial Rate and Higher Rate
During the mortgage boom of the 1990s and early 2000s the mortgage industry created a number of variations on ARMS. A popular one involved a low initial rate that increased later on. The idea was to help younger people and lower income people buy homes.
A borrower would pay a lower rate say 4% or 5% for the first five years of the mortgage. Then the rate would increase to 8% or more. The problem with this was that the economy got worse just as many of the ARMS became due. People were losing jobs at the time their mortgage payments were increasing.
Another problem was that property values fell as mortgages increased. Many of the individuals caught with ARMS could not raise enough money to pay them off by selling their homes. They were trapped in underwater homes, properties that were mortgaged for more than their value.
Refinancing an ARM
Part of the reason why an ARM can be a bad deal is that it is hard to refinance. It is usually fairly easy for a person with good credit to refinance a fixed rate mortgage. It is often hard for a person to get an ARM refinanced.
The Home Affordable Refinance Program a federal scheme to help homeowners facing foreclosure deliberately excludes ARMS. Many lenders will only refinance an ARM if the homeowner has paid the majority of it off.
Given recent history it is a good idea for property buyers to avoid adjustable rate mortgages. The potential costs outweigh the benefits of these loans.
Many of those foreclosures could have been avoided if the homeowners had understood what adjustable rate mortgages are and how they work. Everybody who is thinking about getting a mortgage needs to be aware of how an ARM works.
How an ARM Differs from a Traditional Mortgage
In a traditional fixed-rate mortgage such as a 30-year mortgage the homeowner pays the same interest rate for the length of the loan. The interest rate stays the same so the payments will stay roughly the same.
The interest rate on a fixed-rate mortgage is determined by the prime rate (what lenders pay for money) and the amount of risk the lender takes. If the prime rate is 3% when a mortgage is issued the interest rate will be around 4% to 5% on the average mortgage.
In an Adjustable Rate Mortgage the lender has the right to adjust the interest rate at some point. A common arrangement is that it can adjust the rate to match the prime rate in the future. If the primate rate rose the interest and the amount of the mortgage payments would rise. If it fell the lender could lower the rate and the payments.
Initial Rate and Higher Rate
During the mortgage boom of the 1990s and early 2000s the mortgage industry created a number of variations on ARMS. A popular one involved a low initial rate that increased later on. The idea was to help younger people and lower income people buy homes.
A borrower would pay a lower rate say 4% or 5% for the first five years of the mortgage. Then the rate would increase to 8% or more. The problem with this was that the economy got worse just as many of the ARMS became due. People were losing jobs at the time their mortgage payments were increasing.
Another problem was that property values fell as mortgages increased. Many of the individuals caught with ARMS could not raise enough money to pay them off by selling their homes. They were trapped in underwater homes, properties that were mortgaged for more than their value.
Refinancing an ARM
Part of the reason why an ARM can be a bad deal is that it is hard to refinance. It is usually fairly easy for a person with good credit to refinance a fixed rate mortgage. It is often hard for a person to get an ARM refinanced.
The Home Affordable Refinance Program a federal scheme to help homeowners facing foreclosure deliberately excludes ARMS. Many lenders will only refinance an ARM if the homeowner has paid the majority of it off.
Given recent history it is a good idea for property buyers to avoid adjustable rate mortgages. The potential costs outweigh the benefits of these loans.
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