When contacting a mortgage loan officer, you may hear the term “ARM Loan” used quite a bit. If the term isn’t properly defined, you may come away from the conversation unsure of what the term means, but pretty sure that these types of loans are fantastic.  Be aware, though, that loan officers are usually attempting to talk potential borrowers into ARM loans because they are good for the lender, not necessarily for the borrower in all cases.

An ARM loan is an adjustable rate mortgage.  This means that for a certain period of time the interest rate is set, but then eventually the interest rate becomes adjustable.  This can translate into a higher or lower monthly mortgage payment, depending upon the current interest rates.  Most lenders base their interest rates on the Prime interest rate, so if the federal government raises their Prime rate then it is highly likely that ARM rates will be rising right along side the Prime rate. 

The period of time that the interest rate of an ARM loan is set depends on what type of ARM loan it is.  For example, if a lender refers to a 5/1 ARM this means that for the first five years of the mortgage the interest rate will remain fixed.  After the fifth year, however, the rate can fluctuate up or down once a year, which is what the “1” of 5/1 refers to.  In the same sense, a 3/1 ARM has a fixed interest rate for three years and then once a year fluctuates according to interest rates.  This sort of fluctuation can be of benefit to folks who are lucky enough to have adjustments happen when interest rates are lower than when they initially secured the loan.  The resulting lower mortgage payment is a welcome change.  For most borrowers, however, the fluctuations in interest rates are up.  This can be an annoyance to some and a disaster for others.  A family who is already living paycheck to paycheck will undoubtedly feel a huge financial crunch when their mortgage payment is raised, and in some cases this can result in an eventual foreclosure when they aren’t able to make their monthly payments.

So when is an ARM loan a good idea? People who will not remain in their home for very long can benefit from ARM loans since they can get lower interest rates than with a fixed loan.  If a family only intends on staying at a certain home for five years, for example, getting a 5/1 ARM would be a feasible idea because by the time the interest rate was ready to become variable they will have sold the home.  This is dangerous, however, if the family is not entirely sure that they will leave the residence at a certain time.  If the family secures the loan when interest rates are low and then later decide to stay put instead of moving they may be facing a large leap in mortgage payment after five years is up. 

Remember, financial institutions approve mortgage loans based on the current interest rate.  Do not assume that you will have the capability of paying the higher mortgage payment simply because of a bank’s approval.  It is best to ask the loan officer to figure out what the maximum payment may eventually be and make a decision based on that number.  Luckily most lenders put caps on the ARM loan interest rates, meaning the interest rate on a loan will never climb higher than a certain percentage point.  So even if interest rates climb to ridiculous levels there is only so far an ARM loan interest rate will go in most cases. Additionally, many lenders do not offer adjustable rate mortgage loans for vacation homes and investment properties, but rather only for primary residences.   

If you are offered a stunningly low interest rate on a mortgage, it is quite likely that you are being offered an adjustable rate mortgage, even if the lender does not allude to that.  Be sure to read all the fine print and ask many questions to make sure that a few years down the road your interest rate doesn’t suddenly and unexpectedly go through the roof.

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