The American Dream: Buying Your First Starter Home

An adjustable-rate mortgage is a loan in which the rate can fluctuate over time rather than a fixed rate mortgage in which the rate never adjusts. Adjustable-rate mortgages have their own unique set of benefits and drawbacks.

Adjustable-rate mortgages are considered “hybrid” loans that have a fixed rate for the first few years before the rate starts adjusting. The typical fixed time periods are 3, 5, 7, or 10 years. The adjustments start after that fixed period, and the rate of adjustment is displayed in the second number indicated on the arm loan description.

An adjustable-rate mortgage is an ideal product for the consumer who doesn’t expect to stay in their home for an extended period of time. The average home is resold about every 7 years. If a consumer does intend for that particular property to be their forever home, then it may not be a bad idea to consider a fixed-rate mortgage.

Borrowers tend to be hesitant in obtaining an adjustable-rate mortgage due to the fact that their rate may significantly increase each time it adjusts. Although, adjustable-rate mortgages do have limitations on just how high the rate can go. The cap prevents the rate from going any higher than the indicated cap even over a 30-year term. All of the details will be disclosed in the HUD-1 Settlement Statement.

When the rate adjusts, the new rate will be based on the rate index that reflects the current economic climate. The new rate consists of the index rate plus a certain margin depicted at the time the loan originated. For example, if the index is 4.5% when the rate readjusts and the margin is 2%, then the new rate will be 6.5%. Now as far as the rate cap, if the rate cap is 6% then the highest that particular rate can adjust to would be 6% The most used rate indexes for adjustable-rate mortgages are one-year Treasury securities, the London Interbank Offered Rate (LIBOR), and the Cost of Funds Index (COFI). However, some lenders may use their own index. Either way the index will be disclosed and remain throughout the lifetime of the loan.

There are some features that are not so advantageous for adjustable-rate mortgages. Some have teaser rates, which is a low initial rate that can climb above market rates for adjustable-rate mortgages when it resets. Interest-only loans allow you to pay interest only for a period, but once the principal gets implemented the loan can easily become unaffordable. Prepayment penalties can also be implemented in these types of loans and can be an uncomfortable cost of paying off the loan early.

Adjustable-rate mortgages are a unique option that just may not suit a particular consumer. However, in some situations it can be an ideal financial option.