If you love roller coasters, an adjustable-rate mortgage may be a match made in heaven.
There can be twists and turns, and if you know how to hold on tight, an ARM can be a thrilling and rewarding experience.
In this article, we’ll go over the highs and lows of ARMs, and help you decide if this type of mortgage is right for you.
So hold on tight, and let’s get started!
What Is An Adjustable-Rate Mortgage?
Adjustable rate mortgages, or ARMs, are a type of home loan in which the interest rate can change over time. Unlike fixed-rate mortgages, which have a consistent interest rate throughout the loan term, ARMs have an initial period during which the rate is fixed, after which it may adjust periodically based on an index.
It’s important to carefully consider the terms of an ARM before choosing this type of mortgage, as the potential for fluctuating interest rates can come with both advantages and disadvantages.
How the Variable Rate on ARMs Is Determined
As soon as the fixed-rate period ends, ARM interest rates will go variable (adjustable) and fluctuate based on a reference interest rate (the ARM index) plus a set amount of interest over that index rate (the ARM margin).
ARM indexes are often benchmark rates like prime rates, LIBORs, secured overnight financing rates, or U.S. Treasury rates.
Pros of an Adjustable-Rate Mortgage
Lower Initial Rates
One big advantage of ARMs is that they usually have lower initial interest rates compared to fixed-rate mortgages. This means that an ARM may be a good option if you’re planning to stay in your home for a short period.
For example, if you’re planning to sell and buy a house within a few years, an ARM with a low initial rate may be more affordable at the outset because you’ll be paying a mortgage that’s lower than what you’d have with a fixed rate mortgage of a similar term length.
One thing to keep in mind is payment shock. If your ARM starts with a low rate but increases over time, you’ll be facing significantly higher mortgage payments in the future than you were at the beginning of the loan term.
Another advantage is the flexibility of your payment when mortgage rates change.
With an ARM, you have the amazing option to take advantage of lower payments when interest rates adjust based on changes in the mortgage market. That means that if rates go down, you simply pay less each month.
Cons of an Adjustable-Rate Mortgage
While flexibility is an advantage above, it is also a disadvantage.
If your loan is due to change and rates go up, you would have to pay the higher rate, thus paying a much larger monthly payment.
It’s also worth mentioning that even if you get a great initial rate and it ends up being lower than a fixed-rate mortgage, the total cost of an ARM could end up being higher in the long run if interest rates go up a lot.
Who Should Consider An ARM?
ARMs can be a good option for borrowers who expect their income to increase over time, or who only plan to stay in their homes for a short time.
Someone who should not get an adjustable-rate is someone who can’t handle the swings in payments. While it should be in the loan documentation, ask your lender what the max payment could eventually be and have them show it to you in black and white in the paperwork.
If you do have any reserves (cash on hand) to make those maximum payments for at least a year, then don’t risk it.
For example, if your normal mortgage payment is $1,000 and the maximum payment is $1,500 – make sure you have at least $6,000 in the bank.
Types of ARMs
There are a few different types of adjustable-rate mortgages.
A Hybrid ARM is a type of home loan that combines features of both fixed-rate and adjustable-rate mortgages. Hybrid ARMs typically have a fixed rate for an initial period, after which the interest rate adjusts periodically based on an index.
Interest-only (I-O) ARM
An interest-only adjustable-rate mortgage (I-O ARM) is a type of home loan where you only pay the interest on the loan for a certain period. This keeps the payments low during the interest-only period, but no money is going toward the principal balance.
After the interest-only period ends, you will have to start paying both the interest and the principal on the loan, which will result in significantly higher monthly payments.
A payment-option ARM is a type of home loan where you can pay your monthly bills in a few different ways.
Typically, you can choose the minimum payment, which covers only a small portion of the loan’s interest. By not paying down the principal, your balance does not decrease. However, your minimum payment also stays low.
The interest-only payment, which is similar to an interest-only mortgage, allows you to pay only the interest on the loan for the monthly period.
Payment-option ARMs may be a good choice if you anticipate a lot of future income growth or need a low initial payment to qualify.
Keep in mind that you may have to pay more each month in the future, so you should carefully consider its terms before choosing this loan type.
Adjustable-Rate Mortgages vs. Fixed-Rate Mortgages
Fixed-rate mortgages are different from adjustable-rate mortgages in that the interest rate stays the same for the life of the loan, which could range from 10-30 or more years. They usually start with higher interest rates than ARMs, which can make ARMs more appealing and affordable in the short term. But fixed-rate loans give the borrower the peace of mind that their rate will never go up so high that they can’t make their loan payments.
With a fixed-rate mortgage, the monthly payments stay the same, but the amount that goes toward interest or principal changes over time, based on the loan’s amortization schedule.
If interest rates go down in general, homeowners with fixed-rate mortgages can refinance and get a new loan with a lower rate to pay off the old one.
Adjustable-Rate Mortgage FAQs
Can I convert my ARM to a fixed-rate mortgage?
Yes, you just need to refinance to get into a fixed-rate mortgage.
Are adjustable-rate mortgages ever a good idea?
Of course. Even though they’ve had a lot of bad publicity, ARMs are flexible and offer great potential benefits in certain situations.
If you have questions to see if they would be a good fit for your situation, just give us a call and we can help you figure it out.
Are there limits on how high ARM interest rates can go?
Yes, this is known as the Lifetime adjustment cap.
This cap says how high the interest rate can increase in total, over the life of the loan. Typically, the cap is 5%, meaning that the rate cannot rise by more than 5 percentage points.
Wrapping it Up
If you have short-term plans, adjustable rate mortgages can be a great financial fit.
You can take advantage of really low rates, which will save you tons of money.
Just keep in mind that if your plans change, to be ready to refinance in case rates increase outside your comfort zone.