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What Are Adjustable Rate Mortgages? Are They Good or Bad?

Adjustable rate mortgages, a mortgage product that was developed in the early 80’s as an answer to mortgage rates that were in the upper teens, have enjoyed a checkered reputation in the US. Many people say that they share part of the blame for the real estate collapse that began in late 2007. Sometimes referred to as “predatory loans,” they were frequently offered to people whose income would not support a traditional mortgage for the amount borrowed. The initial adjustment after the “teaser rates” were over triggered a wave of foreclosures, as mortgage payments nearly doubled in some cases, forcing struggling homeowners to default.

The fault however, is not in the product itself but in the way that it was sold. Adjustable rate mortgages are virtually the only type of mortgages available in many countries of the world and offer tremendous flexibility as consumers and lenders “share the risk” of interest rate fluctuations. A simple explanation of how an adjustable rate works would be this:

You wish to purchase a home. Current fixed rate mortgages are at 3.75%. An adjustable rate is on offer for 2.55% for the first two years. An adjustment will be made at the end of that period. Typically these adjustments may be made every 6 months but not to exceed 2% in one year based on a predetermined index like the LIBOR (London Interbank Offered Rate.) Your rates is adjusted based on that index and may go up or down but may not exceed 2% increase in that year. Along with the yearly adjustment cap (2% in this case) there is a lifetime cap as well. The lifetime cap may be 7.5% for instance and is the highest interest rate you can be charged over the life of the loan. The “shared risk” is that the rate may go down (lenders risk) or up (borrowers risk) based on economic conditions.

Mortgage rates are constantly fluctuating and with the prediction that rates will be going up, now may not be the time to consider how to get an adjustable rate mortgage unless you are considering a short term stay in the house. In which case an interest only ARM or a 5/1 ARM might be a more sound financial decision. Whatever decision you make on any mortgage product, educating yourself about the way your mortgage will work should be job #1.

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