Why Variable Rate Mortgages Are Still Risky

“Be aware, educate yourself before you jump in,” said Linda McCoy, president of the National Association of Mortgage Brokers.

Here are the questions and answers about adjustable rate mortgages:

The first digit refers to the fixed rate period (five, seven or 10 years). The second is the number of times the rate can change after the flat rate period – once a year, in these examples. But loans whose rates can change every six months are also common. They are usually quoted as 7/6 months, 10/6 months and so on.

Some loans allow a bigger increase on the first reset — often five percentage points above the starting rate — and then allow increases of no more than two percentage points, said Sean Bloch, a mortgage broker at Long Island. Some lenders take out ARMs based on the borrower’s ability to make payments at the initial fixed rate plus two percentage points, he said.

Most ARMs also cap the total increase over the term of the loan. So if the initial fixed rate is 4% and the cap is 5, the rate cannot exceed 9%, but that still represents a much higher monthly payment.

If you’re confident you’ll be staying in the house for a relatively short period of time – less than the fixed rate period of the loan – an ARM may be a good idea. You can sell the home or refinance the loan before the rate resets. People who can reasonably expect a significant salary increase before the reset — such as medical residents or law students — may also benefit, Ms McCoy said.

But the option may be too risky, for example, for employees who see a variable rate loan as the only way to afford a specific home. “I’m not going to give them an arm,” she said. They could lose the house and much of their investment if they can’t make the higher payments.

Ultimately, it comes down to how comfortable you are with the risk, Kansas State’s Dr. Seay said. “I have a low tolerance for risk,” he said. “I would never have an ARM.”

Yes. After the initial repayment period, ARM rates are based on a benchmark market index and a fixed rate called the margin. Thus, if the index falls, the loan rate may also fall. But many loans have a floor below which the rate cannot go. Ask your lender or review your loan disclosure documents to find out what this rate is.

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