The initial interest rate on adjustable-rate mortgages (ARMs) is currently running about 1 percent lower than the rate on a 30-year fixed-rate mortgages (FRMs). However, borrowers who take advantage of the lower ARM rate expose themselves to the risk of future rate increases. A major consideration is how large that risk is. The risk can be avoided completely by paying off the loan before the first rate adjustment. If the borrower expects to be out of the house in five years, for example, she selects an ARM that holds the initial rate for five years, or (to be safe) for seven years. But since few homeowners can ever be completely certain about how long they will be in their house, rational ARM borrowers will consider how large a future rate increase might be in the event that they ...
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