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Marc Dooley

How Does an Adjustable Rate Mortgage (ARM) work?

Wednesday, August 24, 2011 - Article by: Marc Dooley - CashCall Mortgage - Message

In 1982, the Garn-St. Germain Depository Institutions Act was passed, allowing lenders to offer the Adjustable Rate Mortgage--or ARM, for short. An ARM is a very different kind of loan than the more standard and stable fixed-rate mortgage. But if you're not planning on being in your home for more than 3-10 years (or if you can refinance again in that same time period), the lower initial rates you get with an ARM can be pretty attractive.

There are basically two types of ARMs; the more common "Fully Amortizing" and the "Interest Only" alternative.

Fully Amortizing ARM
You've likely seen these two-numbers-separated-by-a-slash rates (e.g. 10/1) listed when comparing different lenders or loans. Like a fixed rate loan, the monthly payment is calculated to pay off the entire mortgage balance at the end of the term, which is typically 30 years. The loan starts out with a fixed rate that is locked-in for anywhere between 1 and 10 years. But after that, the interest rate adjusts annually for the duration of the loan. Below are the most common types of Fully Amortizing ARMs.

Common Adjustable Rate Mortgages

* 10/ ARM: Fixed for 10 years; adjust every 1 year for the remaining term of the loan.

* 7/1 ARM: Fixed for 7 years, adjusts every 1 year for the remaining term of the loan.

* 5/1 ARM: Fixed for 5 years, adjusts every 1 year for the remaining term of the loan.

* 3/1 ARM: Fixed for 3 years, adjusts every 1 year for the remaining term of the loan.

* 1 year ARM: Fixed for 1 year (12 months), adjusts annually for the remaining term of the loan.

So for example, you could get a 7/1 ARM with an interest rate that is almost always much lower than the rate for a 15 or 30 year fixed rate mortgage locked in the first seven years of your loan. That could translate to a REALLY large monthly savings on your mortgage for that initial 7-year period. But after that first seven years is up, your interest rate will be adjusted annually based on an agreed upon rate index, and could potentially rise to well over those 15 or 30 year fixed mortgage interest rates. If you just winced a bit, that's understandable. However, if you get out of the loan before that first seven years is over (by selling the house or refinancing), no problem; you probably saved yourself a lot in interest. That said, if you can't sell or refi by the end of that introductory fixed rate period, you could have a problem once rates start adjusting each year.

Interest Only ARM
This one's a bit trickier. Like a Fully Amortizing ARM, an Interest Only ARM has a period where the interest rate is fixed, then becomes adjusted annually later on. But with an Interest Only ARM, your monthly mortgage payments during that initial period cover accrued interest only, and do not touch the principal.

Sure, that makes for an even lower monthly payment during that time. But because you're not touching the principal balance, your equity does not increase. And, after the interest-only period expires, the mortgage payment will usually increase dramatically for two reasons. First, the interest rate typically adjusts upward, and second, you now have to start paying off the principal balance over the original loan term. If the market value of the house declines over the initial period, depending on your original down payment, you may not be able to refinance for the total loan amount, and you may not be able to obtain a high enough price by selling the house to cover the outstanding loan amount. An interest only ARM is one of the riskiest mortgage options, and should only be used if you are certain the market value of the house will go up.

Make an informed decision
Put some good thought into what you're doing and make sure you feel comfortable. If you want to lock in today's historically low rates for the entire loan, consider a stable Fixed Rate mortgage. If you're comfortable with a little risk in return for lower initial interest rates and monthly payments, the Fully Amortizing ARM might be for you. And if you don't mind even more risk for even more reward (in the form of even lower rates), the Interest Only ARM could an option.

At CashCall Mortgage, we make sure our loan advisors can walk you through which refi works best for your situation, so you can make the right choice. Feel free to give us a call at 866-690-CASH. The call is free, and I bet you'll find we can get you the mortgage you need at a better price.

Marc Dooley is the Chief Marketing Officer for CashCall, Inc.

CashCall Mortgage specializes in low interest mortgage loans and home refinancing for borrowers with good credit. Founded by the people who created DiTech, one of the first direct-to-consumers mortgage companies in 1995, CashCall Mortgage has streamlined the application and lending process, reducing their own costs and passing these savings on to customers by undercutting banks and other lenders with lower interest rates and no application fees, deposits or points. CashCall Mortgage offers a variety of products such as 10, 15, and 30-year fixed rate loans, FHA Loans, as well as a 125% Second Mortgage, allowing you to borrow up to 125% the value of your home.

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