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An adjustable rate mortgage, or ARM, is a form of
real estate loan whose interest rate and payment
vary as the interest rate market changes. An
adjustable rate mortgage is also known as a variable
rate mortgage.
ARM's have the advantage of offering a lower
initial interest rate than a traditional fixed rate
mortgage because the rate is based on the lower short
term interest rate market. When interest rates
are falling or remain flat, the ARM is an advantageous
type of mortgage. Under these circumstances the
interest rate and, thus, payments will remain low or
even decline.
The ARM, or adjustable rate mortgage, is at a
disadvantage when interest rates are rising.
Rising interest rates can quickly increase the rate
charged on an ARM with a resulting increase in the
monthly payment. If the ARM includes a
prepayment penalty, the borrower is faced with
additional costs to move to a fixed rate mortgage and
lock the interest rate.
Because of the initial low rate of adjustable rate
mortgages, they have been sold to home buyers who may
not have been able to afford the payments of a
traditional mortgage. These are the very people
who cannot make their mortgage payments if interest
rates even rise moderately. Once interest rates
start to climb, the rate on new fixed rate mortgages
climb also making the switch from the ARM to a fixed
rate mortgage out of reach for many ARM borrowers.
This situation occurred at the beginning of the new
millennium. Housing prices were climbing out of
the reach of many buyers. Interest rates were
low and real estate and mortgage professionals started
offering adjustable rate mortgages to these buyers on
the premise that the an ARM had a slightly lower
interest rate than a fixed rate loan and, therefore,
had a payment the buyer could afford. The
thinking by these professionals was that if the
interest rate increased on the ARM, the buyer could
just refinance to a fixed rate loan or sell the home
at what should be an appreciated value.
Unfortunately, what really happened should have
been expected by these professionals and the banks and
institutions that underwrote the mortgages.
Interest rates started to increase causing ARM
payments to increase for many home owners. As
the real estate market softened, as it normally would
due to rising interest rates, home owners with
adjustable rate mortgages found themselves unable to
secure fixed rate financing because of the increase in
the interest rate and monthly payment for the loan.
So, they had no choice but to begin to dump their
homes on the market. This flood of inventory
further depressed home prices.
As home prices continued lower, home owners with
ARM's found they could not make their payments and
could not sell their home for the amount remaining on
their loan. The result was a mass of home
foreclosures. Homes that have been foreclosed
upon eventually are put on the market and this put
even more pressure on the downward spiral of prices.
Interest rates continued to drift higher as the
rest of the economy and commodity prices, including
oil, increased fears of inflation. The massive
meltdown in real estate prices fed further by the
foreclosure mechanism, pushed many home owners into
just giving up on their home payments or filing for
bankruptcy. The net result has been a large
group of people who have lost their American Dream and
a large number of financial institutions who are now
writing off hundreds of billions of dollars in
mortgage losses with many of them going bankrupt
themselves.
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