WHAT IS AN ADJUSTABLE RATE MORTGAGE?
Understanding Adjustable Rate Mortgages
If you don’t expect to stay in your home for more than 10 years, or if your goal is to get the lowest mortgage rate, an adjustable rate mortgage (ARM) could be an attractive loan option.
But what exactly is an ARM? How do they work and who are they for? We’ve created a quick guide for borrowers breaking down ARMs so you can make an informed decision about your mortgage options.
In This Article We Will Consider:
- What An Adjustable Rate Mortgage Is
- How Adjustable Rate Mortgages Work
- How Rate Caps Work
- Advantages of Adjustable Rate Mortgages
- Disadvantages Of Adjustable Rate Mortgages
- Who Should Consider an Adjustable Rate Mortgage
What’s An Adjustable Rate Mortgage?
An adjustable rate mortgage (ARM) is a home loan with an interest rate that adjusts over time based on the market. This is different than a fixed-rate mortgage, which keeps the same interest rate for the life of the loan.
ARMs typically start with a lower interest rate than fixed rate mortgages, so they're a great option if your goal is getting the lowest possible rate. However, your monthly payment can fluctuate, which can make it difficult to budget. Understanding how ARMs work can help you be prepared in case your rate goes up.
How Does An Adjustable Rate Mortgage Work?
ARMs are 30-year loans, meaning you’ll pay back the money you borrowed over 30 years. That time is split into two periods:
First, there’s an initial fixed rate period where your interest rate won’t change (typically the first 5, 7 or 10 years of the loan)
Then, there’s an adjustment rate period where your interest rate can go up or down based on market conditions. For example, a 5-year ARM would have a fixed rate for the first five years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan. Many homeowners will use the changing interest rate to their advantage. If you only plan to live in the house for five, seven or 10 years, buying a home with an ARM and then selling it before the fixed rate period ends can mean a lower mortgage payment. Of course, doing this also runs the risk that you won’t be able to sell the house before your rate adjusts. Fortunately, there are limits, known as rate caps, that protect your rate from changing too dramatically.
How Rate Caps Work
Rate caps limit how often your interest rate changes and how high it can go. They are usually written as 5/1 (2/2/5). Let’s break down what each number means:
5/1: The “5” is the number of years your interest rate is fixed. The “1” indicates that after your fixed-rate period ends, your interest rate can change once per year.
2/2/5: The first “2” means that for the first year of your adjustable rate period, your rate won’t change more than 2%. The second “2” indicates that your rate can change 2% every year after that. The “5” represents the maximum percentage that can be added to the initial rate for the life of the loan.
Rate caps will vary depending on the loan. For example, a 7/1 ARM might have a 5/2/5 cap structure. If you’re considering an ARM, it’s important to review the rate caps so you aren’t surprised by your interest rate (and therefore your mortgage payment) changing.
Advantages of Adjustable Rate Mortgages
Let’s look at some of the benefits so you can learn if an ARM is right for you.
You Can Get A Lower Interest Rate At The Start Of The Mortgage
ARMs typically come with the lowest interest rates, so during the initial fixed-rate period, you’ll likely pay less in interest than with a fixed-rate mortgage.
Your Interest Rate Could Go Down
ARM interest rates are based on average market interest rates, which are measured by an index. Once your fixed-rate period is over, your rate could go down depending on the market.
It’s Great If You Expect To Move Again In A Few Years
If you only plan to stay in your home for a few years, an ARM can give you access to interest rates that are lower than those that you get with a fixed-rate loan. Then, before your fixed-rate period ends, you can sell the home and avoid dealing with a fluctuating interest rate.
Disadvantages Of Adjustable Rate Mortgages
- Your Monthly Mortgage Payment Could Change
It’s difficult to predict what your interest rate will do after your fixed rate period has ended. If your family is already on a tight budget, you may find that assigning a “job” to every dollar is much more difficult when you can’t accurately calculate your mortgage payment.
- Your Rates Might Go Up Over Time
If interest rates goes up, you’ll end up paying more in interest. That’s why it’s a good idea to be ready to refinance before your fixed rate period ends.
Who Should Consider an Adjustable Rate Mortgage?
An ARM can be a great option if you don’t expect to live in the home for more than 5 to 10 years. For example, if you have a job that moves you around often, an ARM might be a way to save you some cash. Since an ARM typically offers lower interest rates than a fixed-rate mortgage, you’ll have a lower mortgage payment while you’re living in the home, and you can sell the home or refinance before your rate changes.
Buying a starter home is another great way to use an ARM. Your monthly mortgage payments will stay low thanks to the lower initial interest rate, and you can plan to sell the home and roll your savings into an upgrade before your fixed-rate period ends.
ARMs can also be a great idea if you’re buying an investment property, with the idea of flipping, or selling, the home after you complete renovations. If you sell the home before your rate can go up, your mortgage payments won’t cut as deeply into your profits.
There are many benefits of getting an adjustable-rate mortgage to finance your home, including a lower initial interest rate. The quickest way to see if an ARM is your best option is to connect with a licensed broker using the form below.
After they have reviewed your finances, they will recommend the best mortgage for your situation. You’ll also get to review other loan options so you can compare monthly payments, rates and terms.
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Now is the time to qualify for a new home loan or refinance. Every point in APR can account for 1,000’s of dollars over the life of the loan. Don’t Delay! Contact an approved loan originator today!