How ARMs Work
The difference between adjustable-rate and fixed-rate mortgages is pretty clear at the outset. Adjustable-rate mortgages have a payment that fluctuates up or down based on the market index the loan is tied to. The reason ARMs have become so popular is that with added risk comes added reward. Since borrowers take on the risk that their rates might rise during the life of the loan, borrowers can generally enjoy a lower monthly payment at the outset than if they had chosen a fixed-rate product.
In good economies and bad, lenders like to get new customers in the door with incentives. The teaser rate is a very sexy attraction, but make sure you know when your teaser ends and your real rates begin.
Note the phrase “at the outset.” ARM rates reset on a particular schedule agreed to by the borrower and lender. In a way, taking out a loan like this is a bit like going to Vegas. If you are willing to bet that rates won't be rising considerably in the future — or if you keep a good credit record and have the option to refinance into a fixed-rate loan the minute you suspect rates are going to rise — ARMs can be a great idea. They get you into a home just as easily with a lower monthly payment at the outset. Just remember that nobody can predict world events. Remember the effect that the terrorist attacks of September 11 had on an already slowing economy back in 2001? People started losing their jobs, rates started rising, and those with ARMs or ARMs with teaser rates felt a terrible pinch.
On most ARMs, the initial rate of the loan is fixed for a period of two or three years. In their best use, ARMs give the borrower a break on payments while they're trying to adjust their spending to cover the overall spending for a new home or condo, which can be quite high (especially once you consider furnishings and other costs). In the short term, ARMs are great because they make home ownership much more affordable.
The galloping gains in home equity over the past quarter-century gave lenders enough confidence to make mortgage products available to a generation of borrowers who for a variety of reasons (poor credit, heavy debt, low down payment) couldn't easily afford or obtain a fixed-rate loan at even the longest term. So lenders got creative. They started dotting the landscape with fixed/adjustable hybrid loans as well as particularly risky inventions like the interest-only ARMs (where only interest and not princi-pal are paid for a specific term) and payment-option ARMs (allowing the borrower to actually pay less than the interest and principal owed during particular months).
When investigating any loan, and particularly an ARM, make sure there is no prepayment penalty. As a borrower, you want maximum flexibility if interest rates head up or down. You also want the freedom to pay off the loan prematurely or to refinance if you see a better deal somewhere else.
As long as the equity train kept on rolling and the economy remained fairly healthy, lenders felt confident offering the products, and borrowers felt doubly confident about snapping them up.
