Types of Adjustable Rate Mortgages

Types of adjustable rate mortgages

There are three main types of adjustable rate mortgages that one can take out; they are Interest-only, Hybrid, and payment option ARMs.

Interest-Only ARMs

Interest-only ARMs only require borrowers to make interest payments, rather than principal and interest payments.  This allows you to have smaller payments for the duration of the interest-only period but does not decrease your outstanding principal balance.  Once the interest-only period is finished, the borrower will be responsible for fully amortizing the loan over the remainder of the amortization period.  For example, if you take out a 7/1 Interest Only ARM on a 30 year amortization schedule, you are taking a fixed rate interest only loan for 7 years and the will be required to amortize the outstanding principal balance over the next 23 years at a variable rate which can adjust every year (that is what the 1 stands for in 7/1).  This payment will increase substantially proportionally to your interest only payment due to the fact that you will need to actually start paying the house down.

This is where most borrowers get in trouble, they do not fully understand the future impacts of taking interest-only mortgages.  It is extremely important that the borrower looks forward to understand if a dramatic jump in interest rates and subsequently their mortgage payment will be affordable for them. 

Hybrid ARMs

A hybrid ARM is the fully amortizing version of the interest only arm.  Rather than making interest payments only for the first few years, a hybrid ARM starts making prinicipal and interest payments starting with the first payment.  Especially for those who plan on staying in their house for a long time, the benefit of a Hybrid ARM may not be there if the spread between the ARM interest rate and the fixed rate mortgage interest rate is not large enough.

Payment-Option ARMs

A payment-option ARM gives the borrower the option to choose from a variety of payments structures each month.  The payment option ARM is usually taken by those individuals who do not have a steady stream of income or are in a very tough financial situation.  While they provide the flexibility of lower payments, there is a cost to everything.  The long term ramifications of using a payment option arm can be disasterous if the loan balance is not monitored carefully.  Let's review some of the payment options that a borrower will be presented with:

1)  A traditional P (principal) + I (interest) payment each month.  These payments will vary based on the amortization schedule that you elect to use.  The lower number of years in your amortization schedule, the higher your payment. 

2)  An Interest Only Payment which will pay your costs for borrowing money but not pay down your property.

3)  A Minimum Loan payment which may be lower than the actual interest-only payment.  This can be referred to as negative amortization.  Basically, the difference between the minimum payment and the interest only payment will be ADDED back to your outstanding loan balance; therefore, increasing your future monthly payments and the total amount that you owe back to the bank.

Payment option ARMs typically have low teaser rates to entice borrowers.  These rates typically only last for a couple of months and then move back up to where other mortgages are.  This is where you have to be extremely careful; banks will suggest that your payments will be very low with these teaser rates, but what they do not tell you is that they are only offering these low rates by taking the difference between your payment and the cost of the loan and adding it back to your loan.  This is called negative amortization as we discussed above.

It is best to stay away from these types of loan products as they will do nothing but put you in a bigger hole than you started with.  They are extremely risky and have many rules that can negatively affect your financial situation.

The bottom line is that if you need to come up with these creative ways to get into a home, that home is probably not for you.  Understand your finances, present and future, and do not over leverage yourself.

<<Part 1 - Introduction to ARMs 
<<Part 2 - Basic Features of ARMs