An adjustable rate mortgage is similar to any variable rate loan in that the interest rate fluctuates. However, with this type of mortgage, the monthly payment usually changes as well.
With these loans, the interest rates and payments remain fixed for a certain length of time. At the end of that time period, the rates and payments are adjusted. This can be a good thing if the interest rates go down. However, if they go up, your monthly payment will too.
If there is an interest rate cap in place, this can limit the amount your interest rates or monthly payments can change at the end of the adjustment period. This can prevent your monthly payments from becoming more than you can handle should rates rise dramatically.
However, if rates go too high, this cap can cause what is called negative amortization. This means the principal balance actually increases because the cap prevents the full amount of interest from being paid each month. The monthly interest balance that’s not paid is then added to the principal, thus increasing it.
Sometimes, you will be offered initial discounts which lower the amount of interest at the beginning of the loan. This is usually a promotional rate and will almost always go up. Be sure to discuss the effects this will have on your loan with your banker.
These loans can be good if you buy a home when interest rates are high and you anticipate the rates going lower in the future. When they do go lower, you can re-finance with a fixed-rate mortgage and lock in the lower interest rate for the remainder of the loan.From Adjustable Rate Mortgage to Banking Information