While looking for a home, one of the most important factors during the homebuying process is determining which mortgage loan will work best for your financial circumstance. One of your options is an adjustable-rate mortgage.
What is an adjustable-rate mortgage, and how do they work? Here is everything you need to know about an adjustable-rate mortgage to determine if this type of mortgage is right for you.
What is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage, or ARM, is a mortgage loan whose interest rate, based on market conditions, adjusts over the loan’s lifetime. ARMs, also called variable-rate mortgages or floating mortgages, have two periods, known as the fixed period and the adjustment periods:
- Fixed period: The fixed period is where the interest rate stays the same. This period can last anywhere from the first 5, 7, or even 10 years of the loan.
- Adjusted period: The adjusted period is when the interest rate changes. These changes occur based on market conditions.
Once the loan hits the adjustment period, the interest rates will adjust periodically, adding to the outstanding balance yearly or monthly. However, there is a limit on how much the interest rate can rise annually and over the loan’s lifetime.
Adjustable-rate mortgages typically start with lower interest rates than fixed-rate mortgages, making this type of loan a great option for those wanting the lowest mortgage rate.
Components of Adjustable-Rate Mortgages
An adjustable-rate mortgage has four components: the index, margin, interest rate cap, and initial interest rate period.
The index is a benchmark interest rate that reflects on general market conditions. Therefore, the index changes based on current market conditions, and these changes and your loan’s margin will determine the interest rate changes for adjustable-rate mortgage loans.
A mortgage lender will determine which index your mortgage loan will use when you apply for an ARM.
The margin is percentage points added to the index by the mortgage lender to determine your interest rate for an adjustable-rate mortgage. The margin is set in your loan agreement with the mortgage lender and will not change after closing.
Margins and Indexes are a big part of what determines your monthly payment.
Interest Rate Cap
Interest rate caps limit how much the interest rate can rise on adjustable-rate mortgages. Mortgage lenders set the interest rate caps, and there are three different caps:
- Initial cap: Limits how much your interest rate can increase when your interest rate first adjusts.
- Periodic cap: Limits the amount your interest rate can increase or decrease from one adjustment period to the next.
- Lifetime cap: Limits how much your interest rate can increase or decrease over the loan’s lifespan.
Initial Interest Rate Period
The initial interest rate period is when the interest rate on the adjustable-rate mortgage loan does not change. This initial period can range from 6 months to 10 years, with the most common initial periods being 3, 5, or 10 years.
Types of Adjustable-rate Mortgages
Three types of adjustable-rate mortgages exist: Hybrid, interest-only (IO), and payment option.
Hybrid Adjustable-rate Mortgages
A hybrid ARM is the traditional adjustable-rate mortgage. This type of adjustable-rate mortgage begins with a fixed interest rate for the first several years, and then the rate will start to adjust.
To better understand hybrid ARMs, these types of loans are expressed in two numbers, given the above information. The first number will indicate the length of time the loan has a fixed rate, while the second number indicates the duration or adjustment frequency of the variable rate.
For example, a 5/1 ARM has a fixed rate for the first five years of the loan, followed by a variable rate that will adjust every year after. Another example is that a 5/5 ARM will have a fixed rate for the first five years of the loan, followed by a variable rate that will adjust every five years.
Interest-only ARMs are adjustable-rate mortgages where borrowers only pay interest on the mortgage loan for a specified period. Once the interest-only period ends, the borrower will begin to pay both the interest and principal on the mortgage loan.
This type of ARM may appeal to those who need to free up funds for something else, such as furniture for their new home. However, the longer the interest-only period is, the higher the mortgage payments will be after the interest-only period ends.
The payment-option ARM allows borrowers to select their payment structure and schedule. For example, borrowers can choose schedules such as interest-only, a 15-30- or 40-year loan term, or any other payment equal to or greater than the minimum required payment.
Remembering the signed contract to pay the mortgage lender back everything by a specific date is essential. Also, interest rates are higher when the principal amount on the loan is not being paid. The payment-option ARM is ideal for those dealing with financial issues, needing money to buy appliances, or trying to pay off other debts. Still, it makes it easy to fall into severe financial trouble.
Advantages and Disadvantages of Adjustable-rate Mortgages
While adjustable-rate mortgages come with many benefits, there are some disadvantages.
One of the most significant and apparent advantages of ARMs is the initial lower interest rate. The lower interest rate appeals to many borrowers and results in lower monthly payments with the potential to set aside more money toward the loan’s principal.
Another advantage of adjustable-rate mortgages is the potential for interest rates and monthly mortgage payments to decrease. If interest rates drop due to market conditions, borrowers will have lower monthly mortgage payments.
Adjustable-rate mortgages have a component called the initial interest rate cap, meaning interest rates cannot rise beyond the initial interest rate cap. The mortgage lender sets the limit, and once the mortgage lender finalizes your mortgage loan, the initial interest rate cap will not change. The initial interest rate cap is a great benefit to adjustable-rate mortgages.
ARMs are great mortgage options for those who want to finance short-term. This allows borrowers to pay low monthly payments until they sell the property.
If you are a borrower who wants a new car, save for a vacation, or even buy new furniture for your home. An adjustable-rate mortgage loan is ideal for those needing more money quickly.
Lastly, if interest rates drop, you will not have to refinance because you are probably already getting the best deal available with the adjustable-rate mortgage loan.
With an ARM, interest rates change. If the market conditions change drastically, causing an increase in mortgage rates, your monthly mortgage payment will increase, potentially causing borrowers financial trouble if not prepared.
While ARMs are flexible, they are not predictable. Since interest rates change, borrowers must be prepared for any sudden changes in their monthly payments.
Adjustable-rate mortgages can be complicated for borrowers to understand. This is because they have many components that other mortgages do not, such as initial interest rate caps, indexes, and margins.
Some borrowers prefer to have a consistent mortgage payment every month. However, the potential fluctuation of adjustable-rate mortgages can cause instability, discouraging borrowers.
Adjustable-rate Mortgages vs. Fixed-rate Mortgages
Borrowers can choose from fixed-rate mortgages or adjustable-rate mortgages, and upon deciding, it is vital to know the difference between the two mortgage loans.
Fixed-rate mortgages have the same interest rate for the life of the loan, which could be anywhere from 10-30 years, whereas adjustable-rate mortgages have interest rates that fluctuate based on market conditions.
Fixed-rate mortgages tend to have higher interest rates, unlike adjustable-rate mortgages that initially have lower interest rates. However, fixed-rate mortgages have the same consistent monthly payments. In contrast, ARM’s monthly payments begin to adjust after the adjustment period based on market conditions, allowing for the potential of an increase in monthly mortgage payments.
Adjustable-rate Mortgage Considerations for Homebuyers
Adjustable-rate mortgages tend to be riskier than other mortgage loans. Predicting what will happen with the index values during the loan’s lifetime can be difficult. Although ARMs often have lower rates upfront, they may have much higher rates as each adjustment period passes, which can be discouraging to borrowers.
Buyers who plan to pay off their mortgage quickly may be better off with an adjustable-rate mortgage because it will allow them to pay lower interest rates over the loan’s short period. However, a stable fixed-rate mortgage might better serve buyers looking for a long-term loan.
Adjustable-rate mortgages are better for certain borrowers, such as those who want to finance short-term or have the financial goal of paying the loan off before the adjusted period begins.
If you are still determining if adjustable-rate mortgages suit you, talk with a mortgage lender to learn more about ARMs and the different types to see which option may be right for you!
Marimark Mortgage is based in Tampa, Florida, and serves the mortgage needs of homebuyers, homeowners, and investors in Florida, Virginia, and Pennsylvania.
We specialize in adjustable-rate mortgages, conventional home mortgages, FHA, VA, and USDA mortgage options, refinance loans, and reverse mortgages. We have worked extensively with cash-out refinancing and help clients to lower their monthly mortgage payments.