Many first time home buyers don’t understand Adjustable Rate Mortgages

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Basically, an ARM is a mortgage loan that has an interest rate that adjusts, or changes, usually once a year. The benefit of an ARM is that it generally gives you a lower interest rate initially. The risk is that the interest rate most likely will go up, which in turn will make your monthly payments rise.

There are many types of ARM loan programs. A standard ARM will adjust its interest rate annually for the life of the loan. More popular ARM programs are the 3/1 and 5/1 ARMs. Lender’s may have many options varying the intial rate period and adjustment period to provide flexibility for the borrower based on their situation.

A 5 Year ARM is a loan with a fixed rate for the first five years that has a rate that changes once each year for the remaining life of the loan. Because the interest rate can change after the first five years, the monthly payment may also change.

Choosing a 5/1 ARM could save you money on your monthly mortgage payment. For example, let’s say you are purchasing a $200,000 house and putting down 20 percent. After borrowing $160,000 at a 7 percent interest rate, your monthly payment on a 30 year fixed rate mortgage is $1,064.48 each month. A 5/1 ARM can get you into the same house but with lower initial monthly payments. With a 5 year ARM you may be able to start out with a 6.25 percent interest rate, therefore making your monthly payments only $985.15 for the first 5 years of the loan.

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However, after the 5 year fixed period, the interest rate can change based on the index. Because of this, it is essential that you be sure you can still afford the monthly payments if interest rates go up. Most 5/1 ARM’s will have a lifetime payment cap that limits how much the interest rate on your loan can rise. Example: Say the index rate rises 3 percentage points from 2.5 percent to 5.5 percent during an adjustment period. That would make an interest rate of 4.5 percent rise to 7.5 percent. However, a 2 percent cap would keep the interest rate at 6.5 percent. This keeps the borrower from having too great a jump in his/her rate.

If you plan to move or refinance prior to the end of the first 5 years of your mortgage, a 5/1 ARM may be right for you. You do need to be aware that some states allow prepayment penalties for hybrid arms. If you refinanced your home or sold it during the first 5 years of your loan, you may have to pay the lender a penalty fee. Find out from your lender the consequences, if any, of paying off the loan during the fixed period.