What Are the Risks of an Adjustable Rate Mortgage?

Reducing Your Risks

Consider the following issues before accepting an ARM.

Discounted Rates - Buydowns
Sellers sometimes pay a fee that allows the lender to offer you an initial rate that's lower than the sum of the index and the margin. The buydown rate will eventually expire.

The Double Whammy
Your payments can rise significantly if your rate is adjusted upwards at the same time the discount expires.

Is a Discounted Rate Worthwhile?
Sellers may raise the price of a home by the amount they pay to buydown your loan. The extra cost may in time override any savings from the initial discount.

Interest Rate Caps

Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.

Periodic caps limit the amount your interest rate can increase from one adjustment period to the next. Not all ARMs have periodic rate caps.

Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.

Payment Caps
A payment cap limits how much your monthly payment can increase at each adjustment. ARMs with payment caps often do not have periodic rate caps. Carryovers
If an interest rate cap has held your interest down even though the index went up, the amount of the increase can be carried over to the next adjustment period.

Negative Amortization
Amortization takes place when payments are large enough to pay the interest due plus a portion of the principle.

• Negative amortization occurs when payments do not cover the cost of interest. The unpaid amount is added back to the loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the loan.

• Negative amortization generally occurs when a loan has a payment cap that keeps monthly payments from covering the cost of interest.

• Negative amortization does not have as much of an impact when real estate is appreciating nicely, so the lower payments may be more attractive to you than paying down the principle.

The Bottom Line
Lenders are required to give you written information to help you compare and select a mortgage. Don't hesitate to ask as many questions as it takes to help you understand every aspect of your loan.