Types of ARMs

Initially, ARMs typically have a lower rate than fixed-rate loans, and that's why people want them — lower rate, lower payment. As homes gained in value over the last twenty years, first-time buyers and buyers with limited incomes began to want payments as low as possible given what they had to pay for the house. The length of time that the interest on an adjustablerate mortgage stays fixed is really important given the interest-rate environment.

Here are a variety of adjustable-rate mortgages that demonstrate this point:

  • One-year ARMs, which have their first adjustment after one year, are popular in a static rate environment or one where people expect rates might go lower. The monthly payment tends to be the lowest of all the ARM choices.

  • Hybrid ARMs have an initial fixed-rate period that lasts a number of years, with rate adjustments coming annually after that — hence the name hybrid. You'll see hybrids come in a variety of flavors: 3/1, 5/1, 7/1 or 10/1 loans — they have fixed rates for the first three, five, seven, or ten years, respectively, and adjust annually thereafter.

  • Option ARMs (also known as payment-option ARMs) have a vari-ety of payment options. In the down real estate market that began in 2005, they got a particularly bad reputation. Option ARMs allow homeowners to choose the particular way they want their payment handled each month. A borrower might go for an option based on a fifteen-year loan, in which the payment applies to interest and principal. Another mimics a thirty-year loan payment, in which less principal gets paid than the fifteen-year option. With the interest-only option, the monthly payment is applied only to interest on that particular month. Borrowers might also choose to make minimum payment that covers only a portion of that month's interest, with the difference added to the loan balance.

  • This last option may be characterized as a way for a borrower to get a break and keep the house if times get tough. On the other hand, it contributes to negative amortization, where borrowers actually owe more on the mortgage than when they started. (This concept is discussed in Chapter 15.)

    All mortgage products do have responsible uses, but only if the borrower plans to be responsible. Option ARMs are best suited to people in fields with sporadic income, such as people who run seasonal businesses and only have the bulk of their cash flow at specific times of the year. A fixed-rate loan would require equal payments throughout the year, and that may not work for people in that position.

    1. Home
    2. Mortgages
    3. Adjustable-Rate Mortgages (ARMs)
    4. Types of ARMs
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