Adjustable Rate Mortgage (ARM) Facts You Must Know

Curious about getting an adjustable rate mortgage? We’re giving you the adjustable arm facts you need to make the right choice.

If you’re preparing to purchase your first home in the near future, you’re probably thinking about the different types of mortgages there are. While most homeowners traditionally opt to pay the same fixed interest rate for the duration of their mortgage, many new homeowners are choosing to save money after every monthly mortgage payment.

If you’re aspiring to become a new homeowner in the near future, you may be asking yourself these questions. While most homeowners traditionally have a fixed mortgage, many new homeowners are choosing adjustable-rate mortgages.

Signing a mortgage is an intimidating

People secure mortgages when they purchase new homes. Mortgages are basically loans that banks or creditors obtain and use as collateral until homeowners can pay them off. Securing mortgages allows homeowners to purchase real estate without paying in full upfront. People typically pay off mortgages in 30 years.

The interest rate on an adjustable-rate mortgage is adjustable and based on an index that reflects the borrowing costs that lenders pay. This interest rate is periodically adjusted to the ever-fluctuating market.

There are two types of mortgages.

Fixed Rate Mortgage

A fixed rate mortgage has a fixed interest that lasts throughout the duration of the mortgage. The interesting change will never go up or down throughout the duration of the loan.

Under a fixed rate mortgage, the principal and interest payments stay the same for as long as the loan lives. Payments are predictable. You can refinance later if interest rates decrease, and if your credit improves.

Adjustable Rate Mortgage

Unlike a fixed mortgage rate, an adjustable rate mortgage (ARM) can change. Under an adjustable rate mortgage, the interest can be lowered for a specified portion of time. Payment starts out lower than fixed-rate loan. Rate and payments can increase drastically, by hundreds of dollars a month.

People interested in ARMs have to consider how much payments can go up and whether they’ll be willing to pay for the maximum amount.

Why Do People Get Adjustable Rate Mortgages?

Under adjustable rate mortgages, people can pay lower monthly payments and save more money. People can pay lower rates especially at the beginning of their loan period.

Adjustable rate mortgages allow borrowers to save more money. People tend to invest the money that they save under an ARM.

People don’t have to refinance when interest rates are falling. Since they’ve agreed to an adjustable rate mortgage, their monthly payments simply adjust according to the market. People with fixed mortgages, on the other hand, will spend lots of time and money refinancing when rates are decreasing.

An adjustable ARM is the best option for borrowers who want to purchase real estate but don’t want to settle in one place for a long time.

What Are the Risks of Adjustable Rate Mortgages?

Adjustable rate mortgages can be risky to take on because interest rates can increase. In a market with rising rates, people pay more per month under an adjustable ARM.

Some caps don’t apply in the initial adjustment phase.

Lenders can take advantage of new homeowners who aren’t well-versed in finance or mortgages. That’s why it’s important to understand what an adjustable ARM is.

What Do Adjustable Rate Mortgages Look Like?

The initial interest rate is the fixed interest rate that borrowers pay at the beginning of their adjustable ARM. They pay this throughout a specified length of time.

This initial interest rate is commonly called a fixed-period ARM or hybrid ARM.

The interest rate of a Hybrid ARM is fixed for a period of time, usually lasting a few years. After this period of time, the interest rate adjusts.

Home loans have a fixed interest of about 5 years under an ARM. After 5 years or so, the interest rate can be adjusted. This type of adjustable rate mortgage is often regarded as a 5/1 ARM.

There are also other periods of time for which fixed interest rates are paid, like a 7/1 ARM, or a 10/1 ARM.

On an interest-only ARM, people only pay interest rates for a certain period of time. At first, payments are small on this type of ARM. However, they increase because borrowers have to pay back the principal and higher interest.

The fixed-rate period is typically lower than a fixed mortgage rate.

After those 5 years or so, the interest rates can increase or decrease throughout the remaining years of the mortgage life.

It may seem like you can save money with initial interest rates.

What Effects an Adjustable Rate Mortgage?

Index Rates Determine Interest Rates

Banks offer adjustable rate mortgages because the borrower agrees to take on higher interest if interest rates rise in the housing market.

Interest rates are based on index rates, like Monthly Treasury Average, LIBOR (London InterBank Offered Rate), COFI (cost of funds index), and CMT (1-year constant maturity treasury).

When these indexes increases, so do interest rates. Likewise, when these indexes decrease, interest rates go down too. How much you pay per month will depend on these fluctuations.

The LIBOR index is frequently used when mortgages are the subject at hand. The LIBOR index is the rate of which banks offer and lend money to one another. When the LIBOR index is high, borrowers under an adjustable rate mortgage will pay higher interest along with the bank.

Margins Make or Break Interest Rates

Lenders will consider and add margins to index rates. A margin is a set of percentage points that will be added to an index rate, and thus, determine one’s interest rates under an ARM. Margins are determined on an individual basis.

Because margins are determined on an individual basis, many lenders will take credit into consideration. People with good credit scores will usually have lower margins, and thus, pay less for a mortgage.

How frequently a rate adjustment fluctuates and adjust is known as the rate adjustment period.

In 2017, adjustable rate mortgages increased due to rising interest rates. With lower FICO scores across the board, people are steering away from locked mortgages and opting to pay less every month. You can get your FICO score by simply requesting your own credit report.

What to Do If You’re Considering an Adjustable Rate Mortgage

Know Your Cap

Caps are limits on how high you could potentially pay. It’s important to understand how much you could end up paying on an adjustable ARM.

There are protective caps that can adjust a height limit on interest rates. They’re known as rate caps. There are a few different ones.

A periodic adjustment cap is a limit on how much an ARM rate can increase or decrease from one adjustment period to the next.

A lifetime cap limits how much an ARM rate can go up throughout the lifetime of the loan.

A payment cap limits how much a monthly payment can increase from one adjustment period to the next.

An initial adjustment cap determines how much an interest rate can increase the first time after the end of the fixed-rate period. It’s typically between 2-5%. The new rate can’t be more than 2-5% higher than the initial rate of the fixed-rate period.

A subsequent adjustment cap determines how much an interest rate can increase during the adjustment period.

A lifetime adjustment cap determines how much an interest rate can increase over the lifetime of a loan. Lifetime adjustment caps are typically no higher than 5%, meaning that borrowers don’t ever pay more than 5% higher than their initial rates.

Consult with Lenders & Loan Officers

Know your maximum payment.

People looking into adjustment rate mortgages should compare adjustment caps between lenders. Even if lenders offer the same initial rates, their adjustment rate caps could differ significantly. Which lender you opt for could make a big difference in how much you pay after the fixed-rate period.

When researching different lenders, have each one provide a worst-case scenario. By doing this, the lenders can calculate the highest payment you may ever have to pay on a potential loan.

You don’t want to underestimate how much interest rates can rise. You can also consult with a loan officer.

ARMs are ideal for short-term homeowners. With ARMs, home values can decrease, interest rates can go up, financial situations change. Prepare.

Understand Your Adjustment Period

The adjustment period is how often the interest and mortgage rates adjust.

For example, the interest rate of a 1-year ARM adjusts once a year. This means that one’s monthly payments change every year.

Other Things to Consider

If you plan to live in a home for only a few years, why pay for a fixed mortgage?

If you expect your income to increase, you can expect to adjust to an increase in interest rates under an adjustable ARM.

An ARM is not for people who aren’t good with their finances.

If you have any questions about which type of mortgage is best for you get free and unbiased help by speaking to a trustworthy mortgage broker.