Definition
An Adjustable Rate Mortgage (ARM) is a type of mortgage loan wherein the interest rate may change periodically during the life of the loan, often in response to changes in a relevant index. The interest rates adjust based on fluctuations in the market, which can potentially lower or raise the borrower’s payments. These changes generally happen annually after an initial fixed rate period.
Key Takeaways
- An Adjustable Rate Mortgage (ARM) is a type of mortgage where the interest rate applied on the outstanding balance varies throughout the life of the loan.
- Initial payments are usually lower in ARMs compared to fixed-rate mortgages, however, the rates can increase significantly during the term of the loans, affecting the affordability.
- ARM rates are tied to a benchmark interest rate, thus making them unpredictable and potentially volatile for long-term planning.
Importance
The Adjustable Rate Mortgage (ARM) is a critical financial term because it refers to a type of home loan where the interest rate varies over the life of the loan.
Unlike fixed-rate mortgages which have a consistent interest rate, the interest rate for ARMs changes regularly based on an index, such as the U.S.
Prime Rate or the London Interbank Offered Rate (LIBOR). This means that a borrower’s monthly payment will fluctuate, which can potentially provide lower initial payments.
Understanding ARMs is crucial because they can provide a less expensive way for individuals to purchase a home, particularly if they plan to sell the house or refinance before the interest rate increases.
However, they also pose a higher risk due to the unpredictable nature of their interest rates.
Explanation
An Adjustable Rate Mortgage, or ARM, is a type of mortgage loan that is commonly used for home purchases when there is a likelihood of rate decreases in the future or if the borrower plans on owning the property for a shorter period of time. The purpose of an adjustable rate mortgage is to offer a lower introductory interest rate than what is typically offered by fixed-rate mortgages.
This can make home ownership more affordable in the short term. The interest on an ARM changes over time, this can be either to the benefit or detriment of the borrower depending upon the changes in interest rates.
The appeal to investors and home buyers is that the initial interest rate for an ARM is typically lower than a fixed-rate loan, providing an advantage to buyers in a strong economy where interest rates may decline. Yet, the potential drawback is that interest rates could rise significantly, increasing the monthly payment for the borrower.
Because of this, ARMs are often used when borrowers plan to sell or refinance their property within a certain period of time, commonly before the first rate adjustment occurs.
Examples of Adjustable Rate Mortgage
Scenario One: John purchases a home at a time when interest rates are particularly high. He can’t afford the high monthly payments of a fixed-rate mortgage, so he opts for an adjustable rate mortgage (ARM). His initial interest rate is lower, making the home affordable. After some years as per their agreement, the interest rate starts to adjust, but luckily for John, interest rates have gone down in the market, so his monthly payment also reduces.
Scenario Two: Susan is a high-income earner who plans to live in a city for five years due to job requirements. She chooses an ARM with a 5-year initial fixed-rate period because she plans to sell the house and relocate before the rate adjusts. This allows her to enjoy lower interest rates and save some money during her short stay instead of choosing a higher-interest, fixed-rate mortgage.
Scenario Three: Mark and Linda are a retired couple who decide to downsize to a smaller home. They go for an adjustable-rate reverse mortgage, a variant of ARM, where they receive payments from the bank every month from their home equity. However, the interest rate over the loan amount keeps adjusting as per the market rate. This helps them sustain their post-retirement life with an additional source of income.
FAQs About Adjustable Rate Mortgage
What is an Adjustable Rate Mortgage?
An Adjustable Rate Mortgage, or ARM, is a type of home loan with an interest rate that can change at designated intervals, typically based on changes in a defined reference interest rate.
How does an Adjustable Rate Mortgage work?
With an ARM, the interest rate changes over time, usually in relation to an index, and payments may go up or down accordingly.
What are the benefits of Adjustable Rate Mortgage?
One of the main advantages of an Adjustable Rate Mortgage is that they often come with lower initial interest rates. Thus, initial payments are lower, making the home affordable for a greater range of people.
What are the drawbacks of Adjustable Rate Mortgage?
The major downside is unpredictability. Your payments could increase over time, making it more difficult to budget for future payments.
Who should consider an Adjustable Rate Mortgage?
An Adjustable Rate Mortgage might be a good option if you plan to sell your home or refinance before the end of the introductory period, or if you are comfortable taking the risk of a potential payment increase.
Related Entrepreneurship Terms
- Interest Rate Cap
- Initial Interest Rate
- Rate Adjustment Period
- Index Rate
- Mortgage Margin
