This is a common question which comes from a lot of home buyers. But despite the frequency, I’m always happy to answer. A failure to understand the inner workings of the adjustable-rate mortgage loan is what got many homeowners into foreclosure trouble over the last few years.

Let’s start with a quick definition. The adjustable-rate mortgage (commonly known as the ARM loan) has an interest rate that will adjust or “reset” at a predetermined frequency — every three years, every five years, etc. This is very different from the fixed-rate mortgage loan, which holds the same interest rate over the entire life of the loan.

The interest rate is one of the factors that determines the size of your monthly mortgage payment, so when the rate increases or decreases the size of your monthly payment changes up or down with it.

Many of the adjustable-rate mortgages given out these days are actually “hybrid” in nature. They start with a fixed interest rate for a certain period of time. After that initial period, the rate will reset or adjust — and it will continue to adjust with regular frequency. This is where the uncertainty comes into the picture, because you never know exactly how the rate will adjust. It typically means an increase, but you don’t know how much of an increase.

ARM Loans, Bad Credit and Payment Shock — A Common Pattern

These types of loans were favored by the subprime lenders you’ve heard so much about lately. When a person has bad credit, they have trouble qualifying for a mortgage loan. And if they do get approved for a loan, they will usually end up paying a higher interest rate than somebody with good credit. This can make the mortgage payments unaffordable for the home buyer, unless … the lender can find a way to reduce the interest rate for the first few years.

And that’s where the ARM loan came in. Subprime lenders would often use some version of the adjustable-rate mortgage to minimize the interest rates for the first few years of the loan. This would make the loan payments seem more affordable to the borrower — at least initially. When you hear the phrase “teaser rate” used to describe mortgage loans, it usually refers to this type of lending practice.

So, John and Jane (both of whom have bad credit) purchase a home through an ARM loan. The rate is relatively low for the first three years, so everything seems fine. While the mortgage payment is a significant chunk of change for John and Jane, they can afford it for now.

After three years, the interest rate resets to a higher rate. And in the case of a subprime mortgage loan given to borrowers with bad credit, the rate usually increases significantly. The next thing John and Jane know, they are suddenly unable to afford their new payment. So they have three options — (1) refinance the loan, (2) sell the home, or (3) suck it up and try to manage the new / larger mortgage payment.

Many people in this situation over the last few years were unable to pursue option #1 (refinancing) because their property values dropped since the date of purchase. So their options were reduced to just two — sell the house or try to handle the new payment. We know from history that a lot of people took the latter route, whether it was by choice or not. We also know that this type of scenario contributed to the record-breaking numbers of home foreclosures we’ve seen over the last two years.

How to Safely Use an ARM Loan

The scenario described above is an example of how not to use an adjustable-rate mortgage / ARM loan. If you plan to keep the home for many years, the fixed-rate mortgage is usually your best bet. As we have seen, you cannot count on being able to refinance the loan before the interest rate adjusts. Nor can you predict how much larger the payment is going to be after the adjustment period.

But there is a smart way to use the ARM loan. ARM loans work out well for a lot of people because they know they will only be in the home for 3-5 years (depending on the ARM loan), at the most. You can save money while you own the home (because of the introductory period of low interest), and then you can sell the home and move before the rate adjusts.

This is not the only scenario where an adjustable-rate mortgage can be used wisely. But it is the most common scenario. The key here is that you (A) understand how this type of mortgage works and (B) choose the best loan type for your particular home-buying situation.

Do plenty of research before picking a type of home loan. This article is only the beginning of your research. Don’t let a mortgage lender tell you what’s best for you — take their advice, sure, but make your own decisions based on thorough research. It’s your financial future, after all.

Citation Note: The original version of this article was written by Brandon Cornett. Brandon is the publisher of the Home Buying Institute, which includes one of the largest libraries of mortgage advice for home buyers.

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