Question

You are about to purchase your first home and receive an advertisement regarding adjustable-rate mortgages (ARMs). The interest rate on the ARM is lower than that on a fixed rate mortgage. The advertisement mentions that there would be a payment cap on your monthly payments and you would have the option to convert to a fixed-rate mortgage. You are tempted. Interest rates are currently low by historical standards and you are anxious to buy a house and stay in it for the long term. Why might an ARM not be the right mortgage for you?

Answer 1

An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan. With an adjustable-rate mortgage, the initial interest rate is fixed for a period of time. After this initial period of time, the interest rate resets periodically, at yearly or even monthly intervals. ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin.

After the fixed-rate period ends, the interest rate on an adjustable-rate mortgage moves up and down based on the index it is tied to. The index is an interest rate set by market forces and published by a neutral party. There are many indexes, and the loan paperwork identifies which index a particular adjustable-rate mortgage follows.

Why you should not consider ARM's

1. The biggest threat of an Adjustable Mortgage Rate is the unpredictable interest rates which can inflate greatly in certain market conditions. In such cases, rates can rise much higher than fixed interest loans, leading to a financial loss for the buyer.

2. Due to a cap on you repayment capability, the loan will keep on dragging for a long period of time. This means that you'll have to a higher interest amount as the loan cannot be paid off before a certain period of time.

3, Since you're not sure if you'll be staying in the house for a long time, then buying a house on a floating rate is not advisable. This is because you'll be having a fixed burden of monthly installment to be paid.

4. Also, in many cases conversion from a floating rate to a fixed rate means not only incurring a heavy amount to be paid for change, but also the fixed interest rate will be significantly higher than floating rate.