ARM Mortgage Loans - The Upside and Downside

ARM mortgage loans or Adjustable Rate Mortgages are loans that have an interest rate that "adjusts" after an initial fixed rate period. How often arm mortgage loans adjust, depends on the terms of the loan.

Adjustable rate mortgages are considered to be riskier than the traditional 30 year fixed rate loans because if interests rise at the specified reset time your monthly mortgage payment will also rise. If you do not budget properly the increased monthly payment may be too high for your present financial situation causing you to default on the loan.

ARM mortgage loans are popular because they have an initial period of lower interest when compared to fixed rate loans. This often allows a borrower to qualify for "more house" than they would with a fixed rate loan. Again, the risk is that if the loan resets at the specified period of 1, 3, or 5 years to a higher interest, the monthly payments will also rise.

Eighty percent of all adjustable rate mortgages fluctuate based on a complex algorithm of indices from one of these three indexes: 1) the 11th District Cost of Funds Index (COFI), 2) the London Inter Bank Offering Rates (LIBOR) and 3) the Constant Maturity Treasury (CMT) Indexes.

Since ARM loans have the ability to reset at a higher rate than the initial fixed rate, why is this a popular loan for many borrowers? The initial low interest is one factor and another factor is that the risk can be mitigated somewhat by "caps" on the rate swings that are inherent in the loan.

Caps on ARM loans occur on two parts of the loan: the predetermined reset periods of 1, 3 or 5 years and the life-of-the-loan term. The reset period cap restricts the amount the rates can change, up or down, in any given period of time and the life-of-the-loan cap restricts the amount the rate can change, up or down, for as long as the mortgage exists.

Adjustable rate mortgages will continue to be a popular type of loan because they are easier to qualify for and the lower fixed rates are very enticing. If interest rates only gradually increase over time and the borrower's income gradually increases there is little risk in this type of loan. If interest rates drop then this type of loan can save the borrower a significant amount of money over the life of the loan. ARM loans have proven to be a valuable resource in the mortgage industry.

It is only when a borrower procures an ARM and is at the extreme limits of his or her borrowing capacity that disaster can ensue. If the ARM resets at a higher rate than the borrower can repay monthly, foreclosure may be the result. Make sure you are completely aware of the terms of ARM mortgage loans, including planning for increased rates, before you sign a contract. If you educate yourself for all the contingencies of this type of loan then you will be prepared to benefit from its advantages.