Adjustable-Rate Mortgages: Three Main Types Defined
Mortgages with adjustable rates can be tempting because they start out at a lower rate than fixed-rate home loans. But a lot of consumers who take out adjustable-rate mortgages, or ARMs, get into financial trouble when their monthly payments are reset and they find themselves unable to afford their mortgages. It's a big problem in this market because falling home prices have left many homeowners with no equity or ability to refinance ARMs.
Make sure you understand what you're getting into with an ARM before you sign anything. To get started, here's a quick rundown of the three main types of ARMs.
A traditional ARM has a regularly-occurring interest rate change. Most common among these are six-month and one-year adjustables, but you may also run across those with three or even five year interest-rate adjustment periods.
A hybrid ARM combines a fixed-rate period of anywhere from two to ten years, followed by an adjustable rate period where the rate most commonly changes just once per year. You may see these loans expressed in print as a "5/1" or verbally discussed as a "ten one". Usually, the first number indicates the length of the fixed-rate period, and the second number tells you how often the rate will be adjusted after that. For example, the interest rate is fixed for the first five years in a 5/1 ARM, and after that the rate is adjusted annually.
With a payment-option ARM, you choose among various alternatives each month, such as a traditional payment of principal and interest, an interest-only payment or a minimum payment that might be less than the amount of interest which is due. No matter what choice of payment you make, these loans usually revert to a fully-amortizing payment structure when certain "recast" triggers are reached. Your monthly payment can increase significantly with each recast, especially if you've been making just minimum payments.
Some ARMs, especially hybrid ARMs, allow for monthly payments comprised of interest only, at least for a while. The interest-only period often coincides with the fixed-rate period (i.e. the fixed five-years of a 5/1 ARM). After that, your monthly payment will go up, sometimes by a lot, because you have to start paying back the principal as well as the interest, and you'll now only have 25 years remaining on your loan over which to do it.
Barbara Marquand is a freelance writer who writes frequently about business topics.