Buying a house is often the most significant financial event many people ever face. Most of us, though, cannot go out and plop down the tens, even hundreds, of thousands of dollars required. Instead, home buyers must often borrow the vast majority of the purchase price - in the form of a mortgage - from a better-heeled group of people such as a bank or mortgage company.

While there is a bewildering array of mortgages, this article focuses on one type - the adjustable-rate mortgage, or ARM for short. In this article, we will take a look at ARMs to see how they work, and uncover some different types of adjustable rate mortgages.

Adjustable-Rate Mortgages (ARM)
An ARM is a type of mortgage in which the rate of interest charged on the borrowed amount varies based on an underlying index rate. As the underlying index rate varies, so does the monthly payment amount on the mortgage. This is the opposite of a fixed-rate mortgage, which sets the rate of interest charged over a set term and the payments do not alter.

In general, an ARM allows a borrower to obtain a mortgage with an interest rate that is usually lower than a fixed-rate type of mortgage, at least at the beginning. The interest rate is usually some fixed amount above an index rate, such as the "cost of funds" rate. As the index rate changes, so does the interest rate on the ARM. (To learn more about ARMs, see Mortgages: Fixed-Rate Versus Adjustable-Rate, American Dream Or Mortgage Nightmare? and ARMed And Dangerous.)

Hybrid ARM
A hybrid ARM is probably the most familiar kind of ARM. It starts off with a period of time, such as five years, in which the rate is fixed. After that time is up, it resets every year to the indexed rate or as close to it as can be managed given limits on annual changes. This type of ARM is especially good if you are going to be in your home for only a few years. You get a lower interest rate during that time and can plan to sell before the monthly payment resets.

Example - A Hybrid Arm Vs. a 30-Year Fixed Mortgage
If you borrowed $250,000 with a 30-year fixed-rate mortgage at 6.5%, your monthly payments would be $1,580.17 for the lifetime of the loan. If, on the other hand, you get a hybrid ARM at 4% for five years and an indexed rate for the remainder, your first 60 monthly payments would only be $1,193.54. They would then change yearly as the interest rate resets each year. If, for instance, the new rate at the start of year six is 8%, then the payment would become $1,745.22. This payment could change up or down, depending on the movement in the indexed rate.

Option ARM
Another type of ARM is the option ARM. This is a type of mortgage that can offer various payment options ranging from a minimum payment option, which is usually less than the monthly interest due, to an accelerated payment option, which will cut down on the term of the mortgage.

Option ARMs are attractive to some borrowers because of their low minimum payments and interest-only options, which allow borrowers to qualify for larger amounts. However, while the lower payments can be attractive to borrowers, these payments do come with some additional risks to borrowers.

Mainly, any difference between the minimum payment and what would be paid under a fully-amortized loan (such as a fixed-rate loan) is added to the amount owed. When the amount owed grows to a certain limit, such as 125% of the original loan amount, or a certain amount of time passes, such as five years, the payment suddenly resets to a level where it now begins to pay off the principal as well as the interest over the remainder of the loan.

Example - Option ARM Payment Scenario
Suppose you borrowed $250,000 with a low teaser rate of 1.5%. Your initial minimum monthly payment would be only $862.80 - very affordable. But, the fully amortized payment at the loan\'s indexed rate of, say, 6.2% would have been $1,531.17, so the difference of $668.37 is added to your mortgage\'s principal every month. In the second year, the terms of your loan might cause the minimum payment to increase slightly to $927.51, but the amortized amount is now $1,659.40 because the indexed rate has gone up to 6.56% - and now $731.89 is being added to the balance each month. By the time Year 5 rolls around, you could be paying a minimum of $1,071.85, while the loan\'s indexed rate has increased to 8%, and you are adding some $940 a month to the principal. Not too bad, so far, but at some point, you\'ve got to start paying down that principal. The bank, after all, wants its money back.
This is where Year 6 comes in and the option ARM resets. Thanks to making only the low minimum payments, you would owe almost $300,000 instead of $250,000. At 8%, monthly payments for the remaining 25 years will be $2,312.10, more than twice what you were paying in Year 5 and almost three times what you paid in Year 1. Ouch!

This type of loan is best for people who want the low monthly payment to start, but can afford a much higher monthly payment. It also is good for those who will move out before the ARM resets.

Note: It should not be used to get a bigger house with a larger loan just because you can (now) afford the low initial payments.

First Aid Treatment for a Painful ARM Bite
If you decide to go the ARM route, especially the option ARM, you can do several things to minimize the pain that will occur when the rate and payment reset. Basically, this all boils down to planning ahead:

  1. Your Payment: Be aware of how much of each payment is going toward interest and how much is going toward principal every month. Try to pay off at least all the interest so that the loan amount is not growing. For the option ARM, this means ignoring those tantalizingly low monthly payments and paying more right from the start. At a 6.2% indexed interest rate, $250,000 will generate $1,291.67 in interest alone the very first month. If you don't pay at least that much, the interest is added to the loan balance, making things worse in the future. (To read more, see Understanding the Mortgage Payment Structure and Be Mortgage-Free Faster.)
  2. Your Lender: Talk to your lender, preferably before you end up paying late or go into default. The owner of the mortgage wants its money back, so it would rather negotiate with you than take your house via foreclosure. You have an incentive to continue paying your loan - after all, you live there. (To learn more about avoiding foreclosure, see Saving Your Home From Foreclosure and Are You Living Too Close To The Edge?)

    You might change the mortgage into a fixed-rate loan or negotiate a balloon payment. That balloon, for instance, can either be paid off by selling the house 13 or 14 years from now or by renegotiating again as the end of the fixed period nears.

  3. Your Income: Bring in more income! You could perhaps get a part-time Saturday job or rent out a room. While the latter won't work for everyone, if there is a college nearby, students are always looking for a place to live and you could find someone you get along with. Just be aware of the income tax implications for this type of solution as well as any local landlord laws.

  4. Your Expenses: Cut all unnecessary expenses. Do you really need all 3,759 channels of that digital cable package or a cell phone for everyone in the family? And what about that third or fourth car? Just because your house has a three-car garage doesn't mean you have to have three cars to put in it.
  5. Your Location: Consider moving. You were able to live in a great house for a low monthly payment, but it might honestly be out of your reach once the amortization truly kicks in. Sell the house and downsize. Hopefully, you can sell the house for at least enough to pay off the principal balance, even if you don't end up making any money on the deal. If you owe more than what it can fetch, you might have to sell it anyway and renegotiate the remaining amount with your lender. Leaving on your own terms is a lot better than being kicked out if the lender forecloses. (Keep reading on this subject in Downsize Your Home To Downsize Expenses.)
  6. Your Government: Rely upon a government bailout. Actually, this is more like a desperate hope. Even if the government can do something, you might not be one of the ones who qualify for its assistance. If you do qualify, the program might run out of money before any of it reaches you. Much better to use the above suggestions than to depend on this one.

Final Thoughts
Adjustable-rate mortgages are great for some people, but they're not for everyone. The fancier versions, such as the option ARM, can be truly dangerous if you aren't aware of the impacts of the inevitable interest resetting. Remember the old saying, "If it sounds too good to be true, it probably is." So, make sure to look beneath the initial glamour for the ugly real terms. If you don't understand it, keep asking your lender until you do. This is your home we're talking about, and you want to keep it that way.

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