Adjustable Rate Mortgage Risks

First-time homebuyers and homeowners alike should know that mortgage lenders offer different kinds of mortgage loans. Common types of mortgage loans in real estate include:

• Fixed-rate mortgages
• Adjustable-rate mortgages

While fixed-rate loans have a constant mortgage interest rate, adjustable-rate loans have a fixed interest rate.

For example, a 30-year fixed-rate mortgage may have a 5% fixed-rate period that does not change over the life of the loan. That means that per the loan terms, your monthly mortgage payments will remain the same for the entire 30 years. There will be no change to the initial interest rate of the home loan.

On the other hand, an adjustable-rate mortgage (ARM) may have an introductory rate, such as an initial fixed-rate period, that fluctuates over time.

An ARM rate might follow the Federal Reserve cost of funds index, which is a benchmark that correlates with ARM loan rate adjustments. That means you might start with a lower interest rate and pay lower monthly payments.

Over time, you will face recurring adjustment periods where your rate changes by certain percentage points. ARMs have lifetime caps which usually limit the maximum interest rate to 5%-6% of the initial interest rate.

With lower initial interest rates, ARMs can benefit some borrowers in the short term. A starting low rate means you pay a smaller monthly payment against your total loan amount.

ARMs offers come with substantial risks, such as higher rates due to interest rate changes in the housing market. Your first adjustment might only raise your monthly mortgage payment a little bit. Subsequent adjustments can put pressure on your financial situation.

Below are the risks most commonly encountered with adjustable-rate mortgages.

Rising Monthly Payments and Payment Shock

ARM variable rates do not care about your personal finances. They can change for the worse over time.

Consider a $100,000 ARM mortgage for a single-family home. The monthly minimum payment on an ARM payment could double in five years. The monthly payment could even triple or quadruple if interest rates reach the interest rate cap in your loan agreement. These kinds of payment shocks may be unavoidable over time.

Negative Amortization

Negative amortization means your monthly payments aren’t enough to make the loan balance go down. You may have a payment option ARM and make only minimum payments that do not include all of the interest due. The unpaid interest is added to the principal on your mortgage.

That means you’ll owe more than you originally borrowed. If your loan balance grows to the contract limit, your monthly payments will increase. For example, if your $200,000 loan grows to $300,000, your payments would be recalculated and increased accordingly.

Refinancing Your Mortgage

You may be able to avoid payment shocks and higher monthly payments by refinancing your mortgage. No one knows what interest rates will be in three, five, or 10 years. If your loan balance is greater than the value of your home, you might not be able to refinance.

Other factors, such as your credit score, down payment, and home equity can further complicate the refinancing process.

Prepayment Penalties

Some mortgages, including interest-only mortgages and payment-option ARMs, have prepayment penalties. If you refinance your loan during the prepayment penalty period, you could owe additional fees or penalties.

A penalty might be 3% in the first year, 2% in the second year, and 1% in the third year. In this case, you could owe thousands if you refinance during those first three years.

Most mortgages let you make additional principal payments with your monthly payment. This is not considered prepayment, and there often is no penalty for these extra amounts.

Falling Housing Prices

If housing prices fall, your home may not be worth as much as you owe on the mortgage. If you have negative amortization, you may owe more on your mortgage than you could get from selling your home.

You may find it difficult to refinance. If you decide to sell, you may owe the lender more than the amount you receive from the buyer.

Speak With a Lawyer

A real estate lawyer can help you decide what kind of loan is most suitable for your financial situation. If you’re close to defaulting on your ARM loan or need help restructuring it, an attorney can also contact your mortgage lender. They may be able to save your home by ensuring your rights are protected every step of the way.