An adjustable-rate mortgage is a type of loan that carries an interest rate that is constant at first but changes over time. For the first few years, you’ll typically pay a low fixed interest rate.
The fixed period can be the first five, seven or even 10 years of your loan. And because you’re typically charged a lower interest rate during this time, compared to what you’d be charged with a fixed-rate mortgage, this will help you save money at least for a little while.
After the fixed period, you’ll enter what’s called the adjustment period, which lasts for the remainder of the life of the loan. This is the part where your interest rate changes at specific intervals, whether it’s every six months or every year.
While it may seem beneficial at first glance, an ARM payment cap could actually prevent your mortgage payment from fully covering future interest increases. This results in negative amortization, which means your loan balance would go up instead of down with each payment.
Cons of Adjustable-Rate Mortgages You could be left with a much higher payment. You might buy more house than you can afford. Budget and financial planning is more difficult. You might end up owing more than your house is worth.
The ARM, however, can pose some significant downsides. With an ARM, your monthly payment may change frequently over the life of the loan.
Pitfalls of Adjustable-Rate Mortgages While you may benefit from a lower payment, you still have the risk that rates will rise on you. If that happens, your monthly payment can increase dramatically.
Pros include low introductory rates and flexibility; cons include complexity and the potential for much bigger payments over time.
An adjustable rate mortgage transfers all the risk from the lender to you. The advantage of a 30-year fixed rate mortgage is that it is a virtually risk-free mortgage. Once you lock in your rate, there's virtually no chance that the rate will go up over the entire term of the loan.
What are the risks to the borrower with adjustable−rate loans? It is harder to budget for loan payments that may increase during the term of the loan, That the market rates of interest may increase during the term of the loan.
Cons of an adjustable-rate mortgage Rates and payments can rise significantly over the life of the loan, which can be a shock to your budget. Some annual caps don't apply to the initial loan adjustment, making it difficult to swallow that first reset. ARMs are more complex than their fixed-rate counterparts.
They help with long-term planning. Borrowers can predict exactly what their payments will be and how long it will take to pay off the mortgage.
Option ARMs normally have a prepayment penalty to prevent the borrower from refinancing within the first two or three years. with negative equity and being unable to refinance to more favorable loan terms tends to exacerbate the impact of a loan that grows to be unaffordable.