Adjustable Rate Mortgage (ARM)

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An Adjustable Rate Mortgage (ARM) is in essence a trade-off of risk levels between the lender and borrower. In a traditional 30-year amortized mortgage, the borrower gets a 30-year guarantee of both rate and payment, and the lender asks the borrower to pay a higher rate of interest versus shorter-term mortgages. In a 5-year ARM for example, the borrower gets a 5-year guarantee of rate and payment, while accepting the risk and reward of any changes in interest rates in year 6 through 30. By the borrower accepting part of the risk, the lender offers a reduced rate versus the longer-term mortgage.

By studying historical index data, the indexes' volatility (like BETA factors used for common stocks & options) and range of movement can be compared. Certainly, we must consider this historical data in accessing our risk adversity to changing rates, but in all cases there are other questions that must be answered first: "How often do we plan on refinancing? How long are we going to own the property? Is cash flow or minimizing our payment important?" After answering these questions and perhaps other questions that may be more specific to our personal situation, we are then able to determine the type of loan that will work best to satisfy our needs.

Often, after answering these questions the risks are either eliminated or minimized, or other trade-offs make the risk less of a risk as we are rewarded in some other way.