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Thursday, February 24, 2011

Adjustable rate mortgages (ARM) and what they are

 

An adjustable rate mortgage (ARM) is a mortgage loan with an interest rate that can adjust up or down at certain intervals based on a current index (commonly the 1 year T-Bill) plus a preset margin. ARM loans were invented and first used in the early 1980’s when the Prime Rate was 21% and mortgage rates were in excess of 10%. ARM loans helped many people to purchase a home because the low interest rates allowed more affordable monthly mortgage payments. Even with the low interest rates today there is a still a place for ARM loans. 

While some adjustable rate mortgages have resulted in a negative amortization, which increases the mortgage loan balance, there are many other types of ARM products that are fully amortized and have limitations on the interest rate increase per adjustment period and over the life of the loan.
 
Also, there are ARM loans that have an initial fixed rate that hold for different periods of time such as 10, 7, 5 and 3 years, then convert into a typical one-year ARM. The fixed rate portion usually carries a lower rate than a typical 30-year fixed-rate mortgage, then they kick in to the current Prime Rate index. These are called hybrid mortgages identified as 10/1, 7/1, 5/1 and 3/1. They all are amortized over 30 years.
 
If a homeowner intends to sell his/her home within the next few years, an adjustable rate mortgage could save quite a bit of money. ARMS usually offer a lower initial rate, compared to the fixed-rate product, allowing you to save some money or sell your home before the first rate change takes place.  For example, a 30-year fixed-rate mortgage today is about 4.875% while a 5/1 ARM has an initial rate of about 3.75%. If you are simply looking for a lower interest rate and have no intention of selling the property in the foreseeable future, financing your home through an ARM is not recommended.
 
Adjustable rate mortgages may involve some risk. It is very important for a buyer to become knowledge of all of the features of ARM products including the adjustment periods, the index that is used in determining the interest rate, the margin which is the spread over the index, the interest rate caps set annually and for the life of the loan, and whether the loan can have negative amortization. In the current economic environment ARM loans today are typically chosen by a financially savvy buyer who is comfortable and knowledgeable with changes in interest rates and real estate values. If you feel you uncomfortable with an ARM, it is best to use a fixed-rate mortgage with which interest rate and payment amount don’t fluctuate.
 
Fred Dawson, Jr. is the executive vice president and chief credit officer for Commerce Bank of Arizona, an Arizona based community bank specializing in serving small to mid-size businesses in Arizona. Fred may be contacted at (520) 325-5200, or fdawson@commercebankaz.com.
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