In most cases, though, you can choose to prepay your mortgage before the term is up, which means you'll owe less interest. Or you can renegotiate the loan to get a lower rate. However, with some loans, you may owe a prepayment penalty. That charge will be explained in your loan agreement.
- You always know your housing costs, so you can plan your budget more easily
- Your mortgage won't increase if interest rates go up
- Initial rates and closing costs are usually higher than for ARMs
- Your monthly payments may be larger than with ARMs
- You won't benefit if interest rates drop, and you'll have to refinance
if you want a lower rate
Adjustable-rate mortgages (ARMs) were introduced in the 1980s to help more buyers qualify for mortgages, and to protect lenders by letting them pass along higher interest costs to borrowers if rates went up during the term of the loan.
HOW ARMs WORK
An ARM has a variable interest rate: The rate changes on a regular schedule — such as once a year — to reflect fluctuations in the cost of borrowing. Unlike fixed-rate mortgages, the total cost of borrowing can't be figured in advance, and monthly payments may rise or fall over the term of the loan.
Lenders determine the new rate using two measures:
- An index, which is often a published figure, like the rate on the Constant Maturity Treasury (CMT) Indexes or the Cost-of-Funds Index (COFI) of the 11th Federal Home Loan Bank District. Be sure to find out which index your lender uses, since some fluctuate more — and change more rapidly — than others.
- A margin, which is the number of basis points or hundredths of a percentage point, added to the index to determine the new rate.
Be careful: Lifetime caps are often based on the actual index plus margin and not on the introductory rate. For example, despite a 2.5% teaser rate, with a 4% actual index plus margin, your rate could go as high as 10% with a six-point lifetime cap.
Negative amortization means you may owe extra interest when the mortgage ends, because interest rates have moved higher than your cap allowed the lender to charge you.
Not all ARMs allow negative amortization. If they do, typically the most that can accumulate is 125% of the original loan amount. Then some resolution must be arranged, such as a lump sum payment or loan extension.
The introductory rate you pay for the first months of an adjustable-rate mortgage is almost always lower than the actual cost of borrowing the money. What it means for the borrower is not only a few months of relief but also lower closing costs. The effect is to make mortgages more accessible to more people.
What it means for the lender is being able to adjust the rate upward within a few months while staying competitive with other lenders.