What is an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) is a type of home loan that offers a changing interest rate over the loan term.
Unlike traditional fixed-rate mortgages, the interest rate of an ARM is not fixed and can adjust based on market conditions. The monthly payments remain lower for the initial years of the loan, making ARMs a popular choice for homebuyers.
However, borrowers should know the interest rate can adjust upward or downward at predetermined intervals, which will affect the monthly payment amount. The loan term and frequency of rate adjustments can vary, and the interest rate cap can limit the amount the rate can increase.
Borrowers should consider their future financial plans and their ability to handle potential changes in monthly payments before choosing an adjustable-rate mortgage.
How do adjustable-rate loans work?
Adjustable-rate loans differ from fixed-rate mortgages, which maintain a constant interest rate over the loan term. Adjustable-rate loans have an initial fixed-rate period followed by a fluctuating rate. This initial fixed-rate period provides a lower initial interest rate, resulting in more manageable monthly payments for homebuyers.
Borrowers must understand the terms and conditions of adjustable-rate loans, such as the loan term, frequency of rate adjustments, and interest rate cap. The loan term can vary, and rate adjustments can occur annually or even monthly. An interest rate cap restricts the maximum amount the interest rate can increase.
For example, if you take an adjustable-rate loan with a 5-year initial fixed-rate period and a 2% interest rate cap, the monthly payments will be based on a low initial interest rate during the first 5 years. After that, the interest rate will adjust annually but will not exceed 2% above the initial rate.
While an adjustable-rate loan may provide lower monthly payments during the initial fixed-rate period, it also carries potential risks. If interest rates rise, monthly payments can also increase, potentially exceeding the borrower's ability to pay. Borrowers must consider their future financial plans and ability to handle changes in monthly payments before opting for an adjustable-rate loan.
Types of adjustable-rate mortgages
There are several types of adjustable-rate mortgages (ARMs) to choose from, each with unique features that can affect monthly payments and interest rates.
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Traditional ARM
A traditional adjustable-rate mortgage has an initial fixed interest rate for a specific period of time, usually 5, 7, or 10 years, after which the rate adjusts according to market conditions.
This type of ARM is best suited for homebuyers who plan on selling their home before the adjustment period.
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Hybrid ARM
The hybrid ARM is a combination of fixed-rate and adjustable-rate mortgages. This type of ARM has an initial fixed interest rate for a specified period, after which the rate adjusts annually or semi-annually.
The hybrid ARM is ideal for homebuyers who want the stability of a fixed rate for a certain period of time, followed by the flexibility of an adjustable rate.
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Interest-only ARM
The interest-only ARM allows the borrower to pay only the interest for a certain period of time, typically the first 5-10 years of the loan term. After the period of interest-only payments ends, the borrower must pay the loan balance with the accrued interest over the loan life.
This type of ARM can help homebuyers save money on monthly payments and use the savings for a down payment or other expenses.
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Payment-option ARM
The payment-option ARM offers a variety of payment options, including a minimum payment that does not cover the interest owed, which can result in negative amortization.
This type of ARM is best suited for homebuyers who want maximum flexibility in their monthly payments. It should be approached with caution as it can cause a significant increase in the loan balance over time.
How interest rates on ARM loans are determined?
The interest rate on an ARM loan may be adjusted periodically over the life of the loan, whereas the interest rate on a fixed-rate mortgage remains the same throughout the loan term. The rate on an adjustable mortgage (ARM) loan is determined based on a combination of factors.
One of the major factors influencing the interest rate on an ARM loan is the index rate. An index rate is a benchmark interest rate that is used to determine the interest rate for an ARM loan. Commonly used index rates in the USA cover the London Interbank Offered Rate (LIBOR) and the 11th District Cost of Funds Index (COFI). The ARM index can also be a benchmark rate like a prime rate, the Secured Overnight Financing Rate (SOFR), or the rate on U.S. Treasuries.
The index rate is combined with a margin, which is the lender's markup, to determine the interest rate for an ARM loan. The margin is determined by the lender and may vary based on factors like the borrower's credit score, loan amount, and the loan-to-value ratio.
The index rate may fluctuate based on changes in economic conditions, and as a result, the monthly payments for an ARM loan may increase or decrease over the loan life. This means that borrowers must be prepared for the possibility of higher monthly payments in the future, which may not be feasible for some homebuyers.
The interest rate on a fixed-rate mortgage is the same throughout the loan term, regardless of changes in the index rate. Fixed-rate loans are ideal for homebuyers who prefer the stability of having the same interest rate and monthly payment for the life of the loan. This can help homebuyers budget for their monthly mortgage payments and plan for the future with more certainty.
The interest rate on an ARM loan is not guaranteed and can change over time. Homebuyers should carefully consider the potential risks and benefits of an ARM loan before choosing this type of mortgage.
Pros and cons of adjustable rate mortgages
Pros
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Lower initial interest rate. ARM loans often have a lower initial interest rate compared to a fixed-rate mortgage. This can lead to lower monthly payments in the short term.
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Potential for future savings. ARM interest rates may adjust lower in the future, potentially leading to lower monthly payments and overall savings on loans.
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More affordability. An ARM loan can make homeownership more affordable for those who might not otherwise qualify for a fixed-rate mortgage.
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Flexibility. ARM loans can offer greater flexibility for borrowers who expect their financial situation to change in the future, such as an expected increase in income.
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Loan term. ARM loans can have a shorter loan term compared to fixed-rate mortgages, meaning that the loan can be paid off sooner.
Cons
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Increased payment risk. ARM loans carry the risk of the interest rate adjusting higher, leading to potentially significant increases in monthly payments.
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Uncertainty. It can be difficult to predict future interest rate changes, leaving borrowers uncertain about their future monthly payments.
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Long-term expenses. While ARM loans may offer lower initial interest rates and monthly payments, they may end up being more expensive over the long term.
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Increased financial stress. The risk of higher monthly payments and uncertainty about future payments can lead to increased financial stress for the borrower.
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Refinancing risk. If interest rates rise significantly, it may be difficult for the borrower to refinance to a lower rate, leading to potentially unaffordable monthly payments.
When to get an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) may be a suitable option for those planning to sell their home or refinance within a few years. ARM loan typically offers a lower initial interest rate and monthly mortgage payment. This can make home ownership more affordable during the introductory fixed-rate period.
Borrowers comfortable with some uncertainty and confident in their ability to handle potentially higher monthly payments in the future can get an ARM loan. The lower interest rate during the initial period can result in significant savings compared to a fixed-rate mortgage, particularly if the borrower intends to sell or refinance before the interest rate adjusts.
If interest rates are expected to rise soon, an ARM loan may offer a lower rate during the initial period compared to a fixed-rate mortgage. For those who believe that interest rates will rise, an ARM loan may provide an opportunity to lock in a low interest rate and save money in the short term.
On the other hand, an ARM loan may not be suitable for borrowers who prefer stability and predictability in their monthly payments. Borrowers who are risk-averse or have a limited budget may prefer the stability of a fixed-rate mortgage, where their monthly payment remains the same throughout the loan term.
The decision to choose an ARM loan or a fixed-rate mortgage depends on individual financial circumstances and future expectations. Borrowers should carefully consider their own financial situation and seek advice from a financial professional before deciding. It's important to fully understand the terms and conditions of the loan, including the interest rate adjustment schedule and any caps on interest rate increases, before choosing an adjustable-rate mortgage.
