The Truth About Adjustable Rate Mortgages

Adjustable rate mortgages (ARMs) have copped a lot of criticism in recent times. If you believe some of what has been said in the media, you might even think that ARMs are the CAUSE of the property market collapse and so many families having their homes foreclosed. So what are ARMs? Why are they so bad… or are they really that bad? And how do they differ from fixed rate mortgages?

ARMs are, quite simply, mortgages where the applicable interest rate varies according to a number of indexes, the most common being rates on one-, three-, or five-year United States Treasury securities. ARMs are characterized by an initial rate and an adjustment period. The adjustment period is the period of time in which the rate on an ARM remains the same. At the end of this period, the interest rate is reset and the monthly loan payment recalculated.

Because the interest rate on ARMs is variable, someone who takes out an ARM is essentially taking the risk that the rate won’t become so high as to make their repayment unaffordable in the future. Likewise, if a borrower is not able to meet repayments that are higher due to a higher interest rate, they may face foreclosure.

The problem is even more acute where an ARM is fixed for a period during which interest rates significantly increase. This, in essence, is what has happened to so many people over the past year. A lot of people took out ARMs fixed at low rates in the initial one or two years and were unprepared for the much higher variable rates that applied at the end of the fixed rate period.

So are ARMs bad? The answer is no. ARMs are inherently no worse that fixed rate mortgages, where the interest rate remains fixed for the duration of the mortgage. They are just riskier in the sense that a borrower needs to be prepared for higher repayments if the interest rate rises. However, the reverse is also true. If the interest rate on an ARM declines, the borrower’s repayments will decrease.

Which brings us to why people take out ARMs in the first place. Because the interest rate on an ARM is often lower than that on a fixed rate mortgage ARMs are often more attractive to borrowers who believe that the interest rate will not rise and, if anything, may decline. With a fixed rate mortgage, on the other hand, the same repayments will apply each month.

Nevertheless, if there’s a lesson to be learned from the record number of foreclosures that have occurred in recent times, it’s that, like life, interest rates are unpredictable. Unless you are willing to take a risk ñ and are prepared for the worst case scenario ñ you may be better off taking out a fixed rate mortgage. Sure, you may not benefit from interest rate declines, but at least you can plan your long term finances based on knowing, for sure, what your mortgage repayments will be.

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