A buyer's market doesn't necessarily mean the odds are stacked in the favor of someone who's looking to purchase a home.
While finding the right home is a big concern to prospective buyers, a bigger concern often arises: home affordability.
That's where different financing options come in.
"Home affordability is a huge issue," said Julie Garton-Good, author of "All About Mortgages: Insider Tips To Financing or Refinancing Your Home." "So that's why a lot of these products came to the forefront."
Adjustable rate mortgages, or ARMs, are mortgages in which the interest rate changes and the payments can go up or down as a result.
The interest rate and monthly payment changes on most ARMs monthly, quarterly, annually, every three years and every five years, and the period between rate changes is called the adjustment period, according to the Federal Reserve Board Consumer Handbook on Adjustable-Rate Mortgages.
"(Consumers) choose them for affordability," Garton-Good said. "Often these loans will have more upfront costs, and some lenders roll them into the loan."
Garton-Good said it's about being able to qualify for more house than they can afford.
"People buy with their gut and adjust with their wallet," she said.
She said 26 percent of all mortgages last year were ARMs -- a much higher percentage than in previous years.
"This is due to the lack of home affordability overall, but also due to the higher-leveraged ARMs entering the picture," Garton-Good said. An example would be ARMs that give three or four payment type options, such as paying interest-only.
ARMs can be attractive because the interest rates can be lower than the rates on a 30-year fixed mortgage, but if consumers don't do their homework and understand the loan's terms, payment shock won't be the only thing that hits hard.
"People gloss over the hard data about the loan," Garton-Good said. "Most people don't read the loan documents."
What Makes Up The Interest Rate?
Garton-Good said the ARM's interest rate is calculated from the index plus the margin.
She said the index is predetermined by the lender based on the product they are marketing. The margin is the total of the lender's cost of doing business plus their profit, which typically ranges from 2 to 4 percent.
The most common indices used by lenders are the one-year constant-maturity Treasury securities, the London Interbank Offered Rate and the Cost of Funds Index, according to the Consumer Handbook on Adjustable-Rate Mortgages.
Garton-Good said the Cost of Funds Index is the most consumer-friendly because it adjusts more slowly.
"The index will rise and fall, but the margin will stay constant for the life of the loan," she said. "Shop for the lowest margin."
Garton-Good pointed out that the number of ARM-originated loans are down somewhat due interest rates . ARM interest rates are limited by two types of caps: periodic and lifetime.
The periodic adjustment caps limit the amount that the interest rate can change from one adjustment period to another after the first one. Lifetime caps limit how much the interest rate can rise over the life of the loan, the Consumer Handbook says.
Payment caps limit how much the monthly payment can increase. The unpaid interest can get tacked onto the loan balance, so even though the payments are lower, the size of the entire loan can get bigger, the Consumer Handbook warns.
If borrowers find that the payment shock has left them struggling to pay their mortgage, they need to make some decisions.
Garton-Good said borrowers should decide if they can keep up with rising payments for the long run that is, as long as they'll keep the property. If not, they should try to refinance into a fixed-rate loan."
It's a better idea to avoid payment shock from the start. Doing that is a matter of finding the right ARM.
One of those might be a hybrid ARM, which is a mix of a fixed-rate period and an adjustable rate period, according to the Consumer Handbook.
In a 5/1 ARM, the interest rate is fixed for five years, and after that, the rate adjusts annually. Other types of hybrid ARMs are 7/1 or 10/1.
"The key is really to obtain an ARM that fits your best financial needs," Garton-Good said. "Besides shopping for the lowest margin, a consumer should also select an adjustment period that coincides with income increases. If it's unlikely that I'll have income increases in the next several years, a 5/1, 7/1 or 10/1 might suit me best."
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