Adjustable rate mortgages (ARMs) are now being used by virtually every kind of mortgage lender. Although they are not the best financial instruments for borrowers, they are acceptable instruments and can be good for lenders. Lenders like the ARM because they have a low risk and they can qualify more borrowers for an ARM than conventional or Fannie Mae loans.

What are ARMs?
Adjustable rate mortgages are home mortgages whose interest rates can be adjusted—usually annually. AMRs have no limit on the upward movement of interest over the life of a loan (there is a limit of 2 percent annual increase of interest), unless a limit is negotiated at the time the loan is approved. This means that as interest rates rise your mortgage payment will rise accordingly. On the other hand, if interest rates drop your mortgage also may drop. Nevertheless, lenders don’t have to lower the monthly payments when interest rates drop. It is at the discretion of the lender whether to lower monthly payments.

Although the value of the mortgage may vary at any time and by any amount, the lender’s interest rates are controlled by government and public economic stability, rather than by the bank’s prime interest rate.

Lender disadvantages

• Some states have recently added to their banking laws limits on the amount and number of raises in a given year and the total amount that interest can be raised over the life of the loan.
  
• ARMs are very competitive, forcing lenders to “make the deal more attractive,” many times at the expense of interest received during the first year or two.

Borrower disadvantages

• With an ARM, a home purchase will not be as inflation proof as with a conventional fixed rate mortgage.
  
• Without a negotiated interest limit or an interest cap imposed by the state or lending association, interest rates could skyrocket, forcing monthly payments to follow.
  
• If interest rates rise, the lender has the option of increasing your interest rate but not your monthly payment, which in effect would extend your payment period to 40 years. The other option is to increase your monthly payment to coincide with the rise of interest.
  
• A severe swing in interest rates could result in negative amortization.
  
• Many ARMs have a prepayment penalty included in the contract.

Lender advantages

• Because ARMs usually do not have to qualify for Fannie Mae guarantees, ARMs have less stringent requirements. Therefore, more people can qualify for ARMs.
  
• Lenders are seldom at risk when interest rates rise. The interest they charge is allowed to rise with rising interest rates.
  
• The lender can raise interest, raise mortgage payments, or extend the length of the loan at their discretion, if interest rates rise. If interest rates drop, they don’t have to lower monthly payment requirements.

Borrower advantages

• ARMs usually have a lower interest rate than a conventional fixed rate for the first one to three years.
  
• The annual rise in interest rates is limited to 2 percent. Some states also have a maximum interest limit over the life of the loan.
  
• Some ARMs are assumable loans.
  
• Because ARMs' qualifying standards are less stringent than conventional fixed rate mortgages, borrowers who have less than perfect credit but have a steady job usually can qualify.
  
• Some ARMs that do not have a prepayment penalty clause can be converted into fixed-rate conventional mortgages, if there have not been any late payments over the 12 previous months.
  
• If you know that you will be living in the house for five years or less, an ARM might be a wise choice because your monthly payments will be less.

Conclusion
If you plan to live in the house for more than five years, a fixed-rate mortgage is the best option, if you have good credit. If you have less than perfect credit but have a steady job or plan to live in the house less than five years, ARMs could be a logical option. However, before agreeing to any terms, investigate and shop around. ARMs are competitive, so choose the lender that gives the best deal. Preferably, try to find:

• an annual interest rate limit
  
• a life-of-the-loan limit
  
• no prepayment penalty
  
• monthly payment reduction if interest drops
  
• the right to convert to a fixed-rate mortgage.