Last week we gave an overview of some of the most popular mortgage loans. Now we’re back to talk about another: the adjustable-rate mortgage.
As the name suggests, an adjustable-rate mortgage is a home loan with an interest rate that adjusts over time based on market conditions. This type of mortgage comes with a 30-year term. The initial interest rate stays fixed for a specified number of years at the beginning of the loan term before it adjusts for the remainder.
Advantages of an ARM Loan
- The biggest advantage of an ARM is the initial fixed-rate term, which, as mentioned above, can provide you a lower initial rate and monthly payment than other loans.
- If you plan to move or sell your house within a few years, you can reap the benefits of a low fixed rate and sell the home before it adjusts.
- If interest rates fall, you’ll be able to reap the benefits without having to go through the costs or paperwork of a refinance.
Disadvantages of an ARM Loan
- While your interest rate may go down, it could also rise. If your interest rate increases, you’ll have a higher monthly payment that you may not have prepared for.
- Some ARMs may have a prepayment penalty. Speak to your lender and make sure you understand the terms of the loan before you move forward.
ARM vs. Fixed-Rate Mortgage
- Fixed-rate loans are most commonly offered as 15- or 30-year terms or custom-term loans. ARMs are typically 30-year terms.
- Your starting rate may be lower for an ARM than a fixed-rate mortgage.
- Your monthly mortgage payment may be more affordable in the first few years of an ARM.
How Does an ARM Loan Work?
Once the fixed-rate term ends on an ARM, the interest rate typically adjusts annually. This new rate is determined by adding the index (an economic indicator used to calculate interest rate adjustments for ARMs) to the margin (a fixed percentage point predetermined by your lender that is used to determine the interest rate for the entire life of the loan).
While this may cause the interest rate to increase, there are caps on how much it can increase. These caps are presented in a series of three numbers: initial cap/periodic cap/lifetime cap.
- Initial cap: This cap is the maximum amount the interest rate can adjust the first time it’s changed after the fixed period.
- Periodic cap: This cap puts a limit on the interest rate increase from one adjustment period to the next. The initial cap and the periodic cap may be the same or different.
- Lifetime cap: This cap puts a limit on the interest rate increase over the life of the loan. All adjustable-rate mortgages have a lifetime.
Here’s an example of a common rate cap: (2/2/5). This means that your interest rate can only change by up to 2% the first time it adjusts. Each annual rate change after that is limited to 2% each year. Throughout the rest of the loan term, the highest the interest rate can go is 5% higher than the fixed rate. So, if your original rate was 3.5%, your interest rate can only go up to 8.5% during the life of your loan.
Different Types of ARMs
The structure of an ARM is presented with two numbers. The first number is how long your fixed-rate period will last. The second number is how often the rate will change every year. Here are the most common ARMs:
A 5/1 ARM has a fixed rate of interest for the first 5 years of the loan. After that, the interest rate will adjust once annually over the remaining 25 years.
A 7/1 ARM has a fixed rate of interest for the first 7 years of the loan. After that, the interest rate will adjust once annually over the remaining 23 years.
A 10/1 ARM has a fixed rate of interest for the first 10 years of the loan. After that, the interest rate will adjust once annually over the remaining 20 years.
Is an ARM Loan Right for You?
Do you think an ARM loan could be the right choice for you? Do you still have questions? Contact us below to learn more!