When a person decides to refinance his home mortgage, he mainly needs to choose between fixed rate and adjustable rate of interest. Some home owners prefer fixed rate while adjustable rate makes sense to others. But many people find adjustable rate mortgage complicated and claim to have come across many bad things about it. ARM can prove to be boon or bane depending on the financial condition of the house owner and the research he has done before opting for ARM. Refinancing using ARM can be done for short term as well as long term loans.
Adjusted Rate Mortgage is a home loan where the rate of interest changes over the tenure of the mortgage. The rates may increase or decrease depending on the market and economic situations. Initially when the person opts for an ARM, the interest rates are lower compared to the fixed rate mortgage. The opportunity of paying lesser amount in monthly installments due to lower interest rate is alluring for borrowers though it comes with a risk of the rates getting increased later.
ARM comes with associated risks, especially when there is no fixed term in the loan. In such cases the interest rates may change yearly or even monthly. Even half percent of increase in rates can increase the monthly payment by thousands of dollars. ARM with a fixed term is safer as for the initial fixed period the lower interest rates are locked. The fixed term is usually short from 6 months to a year, while in some cases, the fixed low interest period may also be up to 10 years. At the end of this fixed term, the interest rates vary as per changes in the margins and housing index. As the rate goes up, monthly installment increases; hence the person must be mentally and financially prepared to pay higher.
ARM can prove to be beneficial in following ways –
• Lower interest rates lead to substantial cash savings and principal reduction.
• Lower Margin – For fixing the interest rate, a margin is added to the value of specific index which is used for interest rates. The size of margin varies with a person’s credit score i.e. higher the credit score, lower is the margin and thus lower is the interest rate.
• ARM is beneficial for people who are confident that their incomes will rise in future, thus enabling them to pay higher monthly payments.
• When people feel that the interest rates are going to drop in future they can opt for ARM.
• ARM is also helpful in cases when people want lower monthly installments in the start of the loan term so that they can use the cash for other purposes.
• ARM loans have a feature of interest rate cap. It can be used to limit the rise in interest rates throughout the loan tenure.
The limitations of ARM can be stated as–
• The increase in interest rates may not always be accompanied by an increase in the person’s income.
• An increase in interest rate reduces the growth of equity and it can prove problematic to sell the house when the housing market is low.
• ARM makes payments unstable as the rise or fall of interest rates cannot be accurately predicted. It also makes financial planning difficult.
The index referred for mortgages and margins added to it changes with individual lenders. The loan terms will decide the frequency of increase in original interest rate and payment associated with a change in market interest rates.
Though ARMs contain the risk of rising in future, they are balanced with a reward of low rate initially. All that is required is a little caution and research to reap the benefits of ARM.
