Must Know Dangers Of Adjustable Rate Mortgages


What Are The Dangers Of Adjustable Rate Mortgages?

Adjustable-rate mortgages, known as ARMs, can be one of the most appealing categories of mortgages because of their flexibility. But they can also wind up costing you an arm and a leg. The dangers of ARMs are few in number, but very severe.They’re potentially hazardous to your finances, and should be scrutinized from a wary, cautious, and informed perspective before you decide to use one as your mortgage of choice.

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Adjustable-Rate Loans

ARMs are based on variable interest rates, not fixed ones. Instead of being locked into the same rate for the lifetime of the loan, you get a loan that’s subject to change. Banks offer a variety of ARM products that usually have a very low teaser rate in the beginning. This more affordable start is later followed by a readjustment of your loan to a higher interest rate for the rest of the repayment period. ARMs generally have caps in place that limit how high the interest rate can go, but those won’t necessarily prevent yours from getting unmanageably expensive.

Uncertainty Of Interest Rates

The rate adjusts or moves based upon a prevailing rate that acts as a barometer or gauge. ARMs may be tied to various indices, such as the prime rate, the LIBOR, or another benchmark of the bank’s choice. If that number goes down, your mortgage interest rate will also fall. Those are the good times. If the index goes up, it could trigger a sudden and significant hike in your rate – which would also make your monthly payments spike. Those could be the bad times if you couldn’t afford the new monthly payments. Banking on an ARM tied to movable interest rates is, therefore, risky, because rates are subject to extreme volatility. Because they’re intimately connected to global markets and investor emotions, rates can go up because of political unrest, economic worries, or even jitters caused by natural disasters.

ARMs Race

Because ARM financing is often less expensive in the beginning, buyers have tantalizing options. They can get into homes at lower price points, or buy bigger or more expensive properties. This is because their initial monthly payments would be lower than with a fixed rate, and they’d need lower incomes to qualify. Fixed-rate loans, by contrast, have consistent payments attached to them. ARMs were very popular before the mortgage crisis, when borrowers were often told that they could use an ARM for the first five years of the loan, save money, and then refinance into a conventional loan or sell the home before the rate adjusted.

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Exploding ARMs

That sounds great on paper. But before many homeowners could refinance or sell their properties, the market crashed. They either found no buyers, or ones who wouldn’t pay the amount required to pay off the entire loan balance. Meanwhile, the clock was ticking. When their introductory rates expired, or the ARMs adjusted, the monthly payments went up, and these homeowners were stuck with expensive loans and homes that were quickly losing value. ARMS can be great tools, but know the dangers first, or you could find yourself in your own financial crisis.
Date of original publication:
Updated on: November 10, 2015

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