For those of you just joining us, this is the second post in a series on how an adjustable rate mortgage works. You can read the first post here.
When Interest Rates Increase
When the interest rate on an adjustable rate mortgage increases and the borrower opts to pay the same mortgage payment as before, they may be given the chance to also increase the term of their loan. This compensates for the higher interest costs. For example, a borrower may have the option to increase the term of their loan from 30 years to 35 or 40 years. This is dependent upon how high the interest rates rise and how long they remain high. In most cases, a borrower can lengthen the terms of their loan from 30 to 40 years. Once the terms of the loan have been extended to 40 years, the borrower is required to increase their monthly payments to offset the extra interest.
When Interest Rates Decrease
In the event that interest rates drop, a borrower has the opportunity to continue paying the same monthly payment amount on their adjustable rate mortgage. This causes the terms of the loan to decrease. In the past, borrowers were given the opportunity to decrease their monthly payment in this case. However, this is rarely an option that is offered today.
Negative Amortization
Some adjustable rate mortgages have negative amortization. This happens when a borrower’s monthly payment is not sufficient enough to pay for interest associated with the loan. As a result, this interest that is not covered in the payments is added back to the loan’s principle. This causes an increase in the loan terms. Negative Amortization can be an uncertain proposition, particularly when home values have dipped or flat lined.
Loan Conversion Options
There are banks that offer loans allowing borrowers to convert adjustable rate home mortgages to fixed rate home mortgages and vice versa. In certain situations, this may be a beneficial program for a borrower. However, it is important to note that these loans typically include a “window period” every few months or years when a borrower can implement their conversion option. Depending on what is happening in the market, this window period might not necessarily occur during a favorable time with regard to the current interest rates. In addition, banks charge fees to enact this conversion option, so borrowers should keep this in mind when they are examining the loan’s true cost.