An adjustable rate mortgage or “ARM” is a mortgage that is amortized over 30 years, however, has an introductory period with a lower interest rate for a certain amount of time.
This type of mortgage allows the borrower to get a lower interest rate to have a lower payment or help qualify for the loan as the introductory mortgage payment is lower than a normal 30 year fixed payment.
There are benefits and also drawbacks or risks to this type of mortgage
The benefits to having an adjustable rate mortgage is the low start rate. This type of mortgage can have an introductory period, or period of time whereby the interest is fixed for x number of years before it begins to adjust according to market rates and a pre-determined margin or amount.
For example; a borrower can get a 5 year ARM. This type of mortgage is fixed for 5 years and then beings to adjust according to a certain margin plus the market index this mortgage is tied to.
In exchange for this risk, the borrower receives a discount on the interest rate. So, for the example above the interest rate may be reduced by 0.5% versus a 30 year fixed mortgage.
This enables the borrower to obtain a cheaper interest rate and thereby a cheaper payment for the first 5 years. Also, this lower payment will help the borrower qualify as it lowers the total debt to income ratio which is used in the underwriting process.
A lower payment and easier qualifying percentage are the main benefits of this time of program.
The adjustable rate mortgage program also comes with risks. A lot of borrowers during the real estate crash of 2010 to 2012 lost their houses due to obtaining ARM loans.
They received the low start rates, but, after the initial introductory fixed period the loans began to adjust and the payments started increasing substantially.
This caused a lot of people to miss their mortgage payments as the increase was untenable. Many people thought they would refinance or sell their property by the time the ARM started adjusting; however, it was too late as all the equity in their property had evaporated.
Getting an ARM is similar to gambling on the future market for interest rates and real estate as a whole. If the rates stay flat or continue to drop and prices continue increasing; it may well be worth it.
However, if the market beings to turn the other way and values start to cool and rates start to increase; once that ARM rate begins to adjust upward that may cause substantial affordability issues and may lead to foreclosure.
As with anything there are risks versus rewards and one may well outweigh the other.