An adjustable-rate mortgage (ARM) is a home loan having a variable interest rate. They usually start with a low fixed rate for a few years, followed by periodic rate adjustments. Adjustable-Rate Mortgage loans can be useful and more flexible when compared to traditional fixed mortgage loans but may also come with a few caveats. This article covers the basics of Adjustable Rate Mortgages to find out if it’s right for you.
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Adjustable-Rate Mortgage Basics: How Does it Really Work?
Based on the conditions of your loan and a benchmark interest rate index selected by your lender, your payments on an adjustable-rate mortgage might increase or decrease as interest rates fluctuate. Therefore, choosing an ARM over a fixed-rate mortgage can save you hundreds of dollars in some situations. But it may not always be the case; if your interest rates increase, you will end up paying significantly more in the long run. Adjustable-rate mortgages are riskier than fixed-rate mortgages, but they also have lower interest rates – at least at the beginning of the loan.
Types of ARMs
ARMs generally have three forms: Hybrid, interest-only (IO), and payment option. Here’s a basic rundown of each of them:
ARMs generally have three forms: Hybrid, interest-only (IO), and payment option. Here’s a basic rundown of each of them:
Hybrid ARM
Hybrid ARMs have a fixed-rate period as well as an adjustable-rate period. The interest rate on this form of loan will be fixed at the start and then begin to change periodically. They are the most common type of ARM loans and offer a perfect balance between predictable fixed rates and the flexibility of variable rates.
It is essential to understand how an ARM loan is denoted. In the loan terms, you will see something like 3/27 ARM. The first number shows the period when the loan interest rates are fixed, and the following number (after the /) denotes the number of years you have to bear the flexible rate.
Interest-Only (I-O) ARM
It’s also possible to get an interest-only (I-O) ARM, which means you’ll only have to pay interest on the loan for a set period of time—usually three to ten years. After this period has passed, you must pay both the interest and the principal on loan.
These programs appeal to those who want to save money on their mortgage in the first few years so that they may put it toward other expenses, such as furniture for their new house. This benefit, of course, comes at a price; the longer the I-O term, the larger your payments will be when it expires.
Payment-Option ARM
Payment Option ARM has several payment choices that you can select from. Payments cover both principal and interest; you may also choose to pay just the principal or just the interest; the options are limitless.
It may seem enticing to pay the bare minimum or only the interest. It’s important to note that you’ll have to repay the lender in full by the contract’s due date and that interest rates are greater when the principal isn’t paid off. If you keep paying just the interest, your debt will continue to grow—possibly to untenable proportions.
Benefits of an Adjustable-Rate Mortgage
Lower Payment During the Fixed-Rate Phase
In the initial fixed-rate period, a hybrid ARM usually has a lower interest rate when compared to a traditional fixed mortgage. Standard ARM terms are 3-year, 5-year, 7-year, and 10-year, and you can select anyone that fits your needs. The shorter-term you choose, the lesser interest you usually have to pay. Your initial interest rate on a 5-year ARM, for example, is locked in for five years before it can change, meaning you’ll have five years of low, consistent payments before the rates adjust.
Flexibility
The most significant advantage of adjustable-rate mortgages is the flexibility it provides. If your life is expected to change in the next several years, such as if you plan to relocate or sell your home, an ARM may be sensible. You can take advantage of the ARM’s fixed-rate phase and sell before the less predictable adjustable phase begins.
Different Kinds of Payment Caps
ARM has several types of caps that are in place to limit the increase of your mortgage rates so it does not go out of bounds. Two of the main caps that are in place are: periodic and lifetime caps. A periodic cap restricts how much your rate can fluctuate over a specific time period, for example, in one year period. While the lifetime cap dictates how much your ARM rate can change over the entire lifespan of the loan.
Assume you have a 1% annual cap on your interest rates, and because of this limit, if rates climb 3% during that year, your ARM rate will only rise 1%. Lifetime caps work the same way; if your lifetime limit is 4% during the loan’s lifetime, interest rates will never exceed this limit. This gives ARM customers peace of mind, and they know precisely the maximum payment they need to make in the worst-case scenarios.
Drawbacks of an Adjustable-Rate Mortgage
Your Payments Could Increase
The most obvious drawback of an adjustable-rate mortgage is the uncertainty of how much you may need to pay. If interest rates rise after the adjustable term begins, your payments may increase; some borrowers may find it challenging to make the bigger installments, especially if your income falls during this period.
Unforeseen Circumstances
The only thing predictable in life is its unpredictability, and having an adjustable-rate mortgage may be another reason for you to be worried. Borrowers with ARMs must budget for when the interest rate changes and monthly payments increase. Even if you prepare carefully, you may not be able to sell or refinance when you desire. You may lose your house if you are unable to make payments after the fixed-rate period of the loan has ended. So it is essential to evaluate your financial condition carefully before opting for an ARM loan.
Prepayment Penalties
Prepayment penalties apply to several ARMs. If you sell or refinance your loan, you may be charged this fee. If you want to sell or refinance your house during the first five years of your mortgage, you should find a lender that does not impose this penalty.
ARMs can be Complicated
When considering adjustable-rate mortgages, there are a ton of variables to consider, and things can quickly get complicated. There are different fee structures, complex rules, and different caps that you must consider when selecting the right lender. If you are not aware of what you are getting into, in most instances, you will end up paying more than fixed rates.
Is an Adjustable-Rate Mortgage Right for You?
The best loan option for you is determined by your financial situation and future ambitions as a homeowner.
Consider an adjustable-rate mortgage if…
- You intend to move in a few years – If you know you’ll only be in the house for a few years (10 years or less), an adjustable-rate loan will normally save you money on interest and monthly payments. Of course, you should have a mortgage specialist do the numbers for you. However, in the broader scheme of things, it might save you a lot of money.
- You know your income will rise – An adjustable-rate loan payment may rise in the future, but if you know you’ll be making much more money by then, it won’t be as concerning. Keep in mind that once ARM rates start to vary, they don’t necessarily rise. In rare circumstances, they may actually diminish. An ARM may be worth the risk if you have the finances to manage it.
- You’re confident in your ability to refinance – You can refinance before your adjustable-rate starts to vary if you expect to have fairly steady finances and employment over the following few years. At that time, you can take out another adjustable-rate loan (at a lower rate) or refinance into a fixed-rate loan for more stability. Just keep in mind that many adjustable-rate mortgages have prepayment penalties, so if you refinance before a set date, you may be charged a fee.
Consider a predictable fixed-rate mortgage if…
- You are not certain about your future finances – Perhaps you are currently between jobs and not sure about your finances in the future. You are just barely making it at the end of the month with your current expenses, and any increase in interest rate will put you in financial distress.
- You want the peace of mind that comes with predictable expenses – Not knowing exactly how much you will spend can set many people off. Fixed mortgage rates give you peace of mind, and you know exactly what you will end up paying.
Final Thoughts
The bottom line with adjustable-rate mortgages is that you must understand what you are signing up for. Your lender should go through some worst-case situations with you, so you don’t get caught off guard by payment modifications. You should consider different scenarios that may affect your finances and ability to pay off the interest 5 – 10 years down the line. Life is unpredictable, so you have to be sure if the few percentage difference at the start of the loan terms makes up for the long-term commitment you are getting into.
