Adjustable-rate mortgages have gotten a bad name, but not all ARMs are poor deals, and sometimes they make financial sense.
Unlike a fixed-rate bad credit mortgage, in which the interest rate stays the same for the life of the loan, an ARM features an interest rate that changes according to an index.
Bad Credit Mortgages: Adjustable-Rate Advantages
An ARM offers a lower interest rate at the outset than a fixed-rate loan, so at least in the beginning, your monthly mortgage payments are more affordable. If interest rates remain low or drop, your loan could end up costing less overall than a fixed-rate bad credit home loan.
The risk is that interest rates will go up, and your loan will reset at higher rates. That means your monthly mortgage payments rise, and you could end up with a mortgage you can't afford.
How ARMs Got a Bad Name
A lot of borrowers got in trouble with payment-option ARMs, which start with low teaser rates and let people choose monthly payment options, including interest-only or minimum payments that don't cover the interest due. Today borrowers of these loans, especially if they made only minimum payments, face huge increases in their monthly mortgage bills as their loans are recast.
Hybrid Bad Credit Mortgage
A hybrid ARM features a low fixed rate at the beginning of the loan term and a cap on how high the interest rate can rise later. With a 4% 5/1 ARM, for instance, the 4% interest rate is fixed for the first five years and then adjusted according to an index and margin every year thereafter.
A hybrid ARM might make sense if you plan to stay in the home less than the fixed-rate period of the loan. If you know you'll sell the house in less than five years, for instance, a 5/1 ARM would let you get a loan with a lower interest rate than today's lowest fixed-rate mortgages.
Index, Cap, Prepayment Penalty: Know the Terms
Plans can change, so even if you think you'll move before the fixed-rate expires, make sure you understand all the loan terms, including the index on which the lender will base future adjustable rates, the margin, and caps on the interest rate. A periodic adjustment cap limits the amount the rate can increase from one adjustment period to the next. A lifetime cap limits the rate increase over the lifetime of the loan. Make sure that any prepayment penalty will expire before you might have to refinance.