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Adjustable-Rate (ARMs)

Now that we have covered the more traditional types of loans, let's depart into the more complex world of adjustable-rate mortgages, which can cause some confusion among borrowers. ARMs are available through conventional and FHA sources, so borrowers of all income levels may consider this payment structure. Unlike fixed-rate mortgages, these loans involve interest rate adjustments over time. ARMs are considered riskier loans because the interest rate is likely to increase as the term of the loan progresses.

Most ARMs are built on a 30-year mortgage plan. Borrowers choose their initial term, during which an introductory rate is applied. For example, in a 7/1 ARM, your introductory rate would be fixed for the first seven years. You would then pay adjusting rates for the next 20 years subject to certain "caps" on the rate change and life of loan change. Similarly, for a 5/1 ARM, you would pay the introductory rate for five years and then you would have a rate that continually adjusts the remainder of the term.

Adjustable-rate mortgages can be difficult to understand because they are relatively complex. Your loan acts like a fixed-rate mortgage during the introductory term but is tied to an interest rate index such as the LIBOR. After the introductory period, your rate can and most likely will increase subject to certain 'caps' defined in your note. That means that your loan rate can fluctuate by several points every year thereafter; it is periodically re-evaluated after the introductory period ends. The index value is tied to a variety of economic factors that can cause fluctuations in the industry standard interest rates.

Your interest rate may fluctuate but there will be a designated annual cap to prevent an overwhelming hike in your interest rates in a short period of time. Still, the first adjustment after your lower-rate introductory period may be a shock, because different caps may apply to that initial change. That is, your payments could skyrocket after the initial introductory period -- and you could be left in the lurch if you have not planned ahead.

That is why we recommend the ARM loan for people who intend to stay in their homes for only a short time. If you think you will be leaving the home within a five-year window, it may make more sense to save money on your monthly payments by enjoying a lower rate and then selling the house before the interest amount is adjusted. This is a significant gamble, however, and borrowers have suffered financial consequences when they stay past their anticipated move date. This is why ARMs are generally considered riskier, but they can be beneficial for short-term buyers.

Borrowers can always choose to refinance an ARM, but this can be a potentially costly move considering the thousands of dollars required to complete the process. It is important to weigh the advantages of an ARM over the fixed-rate option.

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