Adjustable Rate Mortgage

The adjustable rate mortgage (ARM) is worth more than one post.  I last wrote that its great draw—a low initial interest rate—can be worked to a homebuyer’s advantage,  But, I spent more time explaining how the interest rate, being variable, can also be a pitfall.

There are some other features about this type of loan that have a double-edge.

You often hear an ARM called an option mortgage.  The option refers to the type of monthly payment you choose.  Lenders will offer several choices:

1)      Interest only

2)      Minimum payment

3)      Fully amortized

Only the fully amortized option (usually set up for 30 or 15 years) is designed for you to actually pay off the principal of the loan.  (Amortization is the gradual paying off a loan over a scheduled period of time.)  This involves paying back a designated portion of your principal along with all interest accrued each month.  (Paying against the loan principle gives you value—equity—in your property.)  Payment amounts will vary according to your current interest rate.  Also, if you opt (often or even occasionally) to use either of the other payment methods, the amount you pay against the principal will have to be refigured to keep your payoff on schedule.

—Yes, with this type of mortgage you can change your payment type from month to month.  But, the consequence of regularly using the interest only and the minimum payment options of an adjustable rate mortgage is that little or no equity is accrued and negative amortization is possible.  (Negative amortization is an increase in the unpaid balance of loan principal.  This contrasts with equity, which is an increase in the value you actually hold in your property as you pay off the principal. )

Consider:

1)   If interest only payments are made, nothing happens to diminish the principal.    

If this is your practice for the life of the loan, the whole of the principal will be due at the end.

2)   A minimum monthly payment is set in the mortgage contract.  Given that the  

      interest rate will vary, it’s quite likely that making minimum payments will

      not cover the interest owed at any current time, much less reduce the

      principal.  When this happens the monthly excess is added to the principal.  At

      the conclusion of the contract you could owe more money than you originally

      borrowed.

Lenders see a risk of not recouping principal in both these scenarios.  Limits may be set as to how long into the life of the loan these options are available.  However, if you—the borrower—choose to use these payment options, you need to be financially prepared at some point in time to assume fully amortized payments or to make what could be an extremely large payment at the end your contract (a balloon payment).

Paying off a mortgage is a long-term endeavor.  During that time, the status of both your personal finances and the general economy can fluctuate.  Most people, being familiar with charges that are fairly uniform, adjust their whole lifestyle to accommodate financial cycles and continue making payments.  An ARM may allow a homebuyer the luxury downsizing what is likely to be his largest payment—the house payment.  Frequent use of the interest only or minimum payment options can mask serious, deteriorating financial issues that will have to be addressed before the end of the mortgage contract.

The variable (and likely, rising) interest rate of an ARM along with the payment options feature can add to the challenge of successfully buying a house.  However, if you buy property with the intent of a quick resale (and therefore, are unlikely to be long in the mortgage contract) or are familiar and comfortable with large fluctuations in your income that will allow you to make an occasional large payment against the principal, an adjustable rate mortgage (an option mortgage) might be viable.