We have heard terrible things about adjustable rate mortgages. Are they so bad?

— E. Martin, Rancho Vistoso

An adjustable rate mortgage is a mortgage loan with an interest rate that can adjust up or down at certain intervals based on a current index (commonly the one-year T-Bill) plus a preset margin.

ARM loans were invented and first used in the early 1980s, when the prime rate was 21 percent and mortgage rates were in excess of 10 percent. ARM loans helped many people to purchase a home because the low interest rates allowed more affordable monthly mortgage payments.

Even with the low interest rates today, there is a still a place for ARM loans. While some adjustable rate mortgages have resulted in a negative amortization, which increases the mortgage loan balance, there are many other types of ARM products that are fully amortized and have limitations on the interest rate increase per adjustment period and over the life of the loan.

Also, there are ARM loans that have an initial fixed rate that holds for different periods of time such as 10, seven, five and three years, then converts into a typical one-year ARM. The fixed rate portion usually carries a lower rate than a typical 30-year, fixed-rate mortgage, then it kicks into the current prime rate index. These are called hybrid mortgages identified as 10/1, 7/1, 5/1 and 3/1. They all are amortized over 30 years.

If a homeowner intends to sell his or her home within the next few years, an adjustable rate mortgage could save quite a bit of money. ARM loans usually offer a lower initial rate compared to the fixed-rate product, allowing you to save some money or sell your home before the first rate-change takes place. For example, a 30-year fixed-rate mortgage today is about 4.875 percent while a 5/1 ARM has an initial rate of about 3.75 percent. If you are simply looking for a lower interest rate and have no intention of selling the property in the foreseeable future, I don’t recommend financing your home through an ARM.

Adjustable rate mortgages may involve some risk. It is very important for a buyer to become knowledgeable of all of the features of ARM products, including the adjustment periods, the index used in determining the interest rate, the margin spread over the index, the interest rate caps set annually and for the life of the loan, and whether the loan can have negative amortization.

In the current economic environment, ARM loans today are typically chosen by a financially savvy buyer who is comfortable and knowledgeable with changes in interest rates and real estate values. If you feel uncomfortable with an ARM, it is best to use a fixed-rate mortgage with which interest rate and payment amount don’t fluctuate.

Karmin Laramie Lynam is a mortgage loan officer at Commerce Bank of Arizona, a locally owned community bank specializing in serving residents and small to mid-size businesses in Arizona. Karmin may be contacted by calling 797-6655 or e-mailing klaramie@commercebankaz.com.

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