A trend began in the late 1990s that many believe is the cause of the recent credit crisis. What was this trend? It was the gradual shift to variable-rate mortgages, which remain the most popular kind of mortgage loan on the market. Also known as an adjustable-rate mortgage or “ARM” loan, these mortgages were originally designed for a specific purpose, and so come with larger risks for many homeowners than traditional fixed-rate mortgages.
One of the largest risks of ARM loans – and the one responsible for the most foreclosures — is the potential for high “caps”, or maximum interest rates. These caps are set by the lender and some can be quite high, though most are within a moderate range. Initially, these mortgages start out with an exceptionally low interest rate, which is often what persuades customers to utilize a variable-rate mortgage.
The risks of variable-rate mortgages are especially high when the market is not very settled. In such times, these loans are little better than a gamble. When the market rates increase, so do the payments. Sometimes, those payments can rise to crippling levels for the homeowner.
ARM loans have the potential to be quite a bargain by allowing borrowers to pay much less in interest than they would with a fixed-rate loan. For this reason, it often attracts many borrowers, yet it is still a huge gamble.
Adjustable-rate mortgages were designed for short-term borrowers such as real estate investors or borrowers who intend to refinance within a short period of time. Often the requirements for these loans are less stringent than fixed-rate, so many use them until improvements are completed on a house, time limits on negative credit pass or until a larger down payment can be raised.
Before you choose a variable-rate mortgage, it’s best to plan on using it for a short period of time. Keep in mind, for future reference, that you’ll need to refinance to a fixed-rate as soon as you are finished with the home improvements, raised your larger down payment, etc. If you remember why you chose this type of loan in the first place and to refinance to a more stable loan as soon as possible, you can dramatically minimize the risks.