Adjustable-Rate Mortgages

Benefit from falling interest rates

Adjustable-rate mortgages (ARMs) offer a low introductory fixed rate of interest for anywhere from a couple of months to three years or more. At the end of the initial period, the mortgage readjusts to the prevailing rate of interest, usually based on the London Inter-Bank Offered Rate (Libor) plus two or three percent for the bank's margin. The rate adjusts every year for the duration of the term of the loan. In 2007, this has become a major problem, as loans move from low fixed rates to higher adjustable ones. Foreclosures, especially among sub-prime loans, are now commonplace.

ARMs became popular in 2001 as interest rates began to drop, moving to historically low levels, rarely seen in this country. At the end of 2000, a one-year ARM was 7.1 percent. By the end of 2003, that same mortgage was 3.97 percent, a 40-percent decrease in rates in just three years. Their market share grew to 33 percent of all outstanding mortgages. They would become the loan of choice, allowing homebuyers to secure bigger mortgages for their bigger homes. All was well.

Unfortunately, as the country is now witnessing, the rates have moved back up, not quite as high as seen in 2000, but still relatively lofty. At the same time, the economy has slowed down and all those having to convert to the adjustable rate are finding themselves woefully unprepared. Who's to blame for this situation? It's hard to say, but it's sad that a third of all mortgage owners don't know what type of product they own; further, those that do understand what they hold have no idea what they will do when it does adjust. The lack of financial understanding is a concern.

So when is an adjustable-rate mortgage a good idea?

There are situations where it makes sense to own an ARM. The most obvious is if you know you are only going to be in a home for a short period of time - say three years. Then it's a good idea to get the low initial rate. A second example would be if interest rates started another steep decline, like in 2001. Then, you want to be able to take advantage of the annual readjustment. Lastly, if you are buying a second home and want to minimize your cash outlay in the initial year or two to accommodate furniture purchases, etc., this makes sense, especially if you are going to rent it out for a portion of each year.

Otherwise, the 30 year fixed-rate mortgage is the way to go.

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