Final answer:
An adjustable-rate mortgage (ARM) responds to inflation by adjusting interest rates. Borrowers may initially benefit from lower rates with ARMs compared to fixed-rate loans, but they face the risk of substantial rate increases over time. It is imperative for borrowers to understand these potential increases in their future mortgage payments.
Step-by-step explanation:
When debating on whether to take an adjustable-rate mortgage (ARM), it is essential for borrowers like Jeff to understand how inflation can impact the interest rates on their loans. If inflation rises by a certain percentage, the interest rates on ARMs often adjust accordingly to reflect the increased cost of living. For example, if inflation rises by 3%, the interest rate on an ARM would also increase by the same percentage to maintain the real cost of borrowing.
Additionally, the introductory rate for an ARM is typically lower than fixed-rate loans. This is because ARMs transfer the risk of increased inflation away from the lender, reducing the risk premium on the interest rate. However, it is crucial for borrowers to be aware of this because the rates of an ARM can jump significantly after the introductory period, as demonstrated where rates can rise from 4% to as much as 6-8%, notably increasing the monthly mortgage payment.
Loans with inflation adjustments built-in, like ARMs, are designed to protect lenders from losing money in real terms due to rising inflation, and allow them to offer lower initial rates to borrowers. Yet, the flip side for homeowners is the risk that significant interest rate increases can make the loan much more expensive over time.