An adjustable-rate mortgage offers a fixed mortgage repayment for a defined period of 1,3, 5 or 7 years before reverting to a variable rate. The new rate of interest is then linked to a variable index and will be topped-up with a further margin. For example, if the 1-year ARM index is 5.2% and the margin is 2%, the new interest rate will be 7.2%. According to the Mortgage Bankers Association (MBA), only 2.3% of all mortgages are currently ARMs. This is mainly due to the current popularity of fixed-rate loans. A 30-year fixed-rate mortgage operates differently to an ARM as the rate is constant for the full duration of the loan.
Advantages of an Adjustable-Rate Mortgage
- Low interest rate. A homeowner to benefit from a lower interest rate in the short term.
- Monthly repayments. A reduced interest rate will mean that a homeowner will pay a lower monthly mortgage repayment in the short-term.
- Flexibility. An ARM provides greater flexibility than a fixed-rate mortgage. If rates continue to fall, it may be possible to borrow money more cheaply with a fixed-rate loan at a later date.
- Moving house. Individuals who plan to move house in the next few years are likely to find that an adjustable-rate mortgage is cheaper. Fixed-rate mortgages impose a number of charges for early redemption that will be deducted from any available home equity.
Disadvantages of an Adjustable-Rate Mortgage
- Rising interest rates. Once the fixed period reaches a conclusion, mortgage repayments will rise in-line with any future interest rate increases. This is the main attraction of a fixed-rate mortgage.
- Financial uncertainty. The variable nature of an ARM could create financial difficulties for homeowners who are on a fixed income. Whilst it benefits them when interest rates fall, it can create hardship when central banks are trying to tackle inflationary pressure.
- Mortgage refinancing. Entering an adjustable-rate mortgage because rates are low with the intention of refinancing later on is rarely a good idea. In all likelihood, the Federal Reserve will increase interest rates as the economy starts to improve. This means that the best mortgage deals become increasingly difficult to find. Mortgage refinancing will also incur further costs.
- Budgeting. Variable rates can make household budgeting more of a challenge.
Adjustable-rate mortgages provide an opportunity to reduce mortgage repayments in the short-term, but it will mean higher payments over the full duration. A 15-year fixed-rate mortgage not only provides greater repayment certainty, it also has an interest rate that is, on average, lower than an ARM.
Sources
(May 8, 2009). "Weekly Mortgage Applications Survey." The Mortgage Bankers Association (MBA).
Disclaimer: This article in no way attempts to give legal or tax advice. One should consult a licensed attorney, tax advisor, or other qualified professional.
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