As fixed rate mortgage rates climb higher, adjustable-rate mortgages are starting to become a more desirable option for some borrowers.
Though not as popular as its fixed-rate counterparts, ARM mortgages can be a good option for buyers in some circumstances. Some buyers are wary of these loans after the 2008 financial crisis. Others just aren’t sure how they work!
Regardless of where you stand, we’re here to explore the adjustable-rate mortgage, answering basic questions you may have and shining light on this financial tool.
What is an ARM mortgage?
An ARM is an adjustable-rate mortgage— a type of home loan where the interest rate can change over the life of the loan. With an ARM, the interest rate typically starts lower than those of fixed-rate mortgages. After the introductory period, the rate will fluctuate to reflect the prevailing interest rate.
Important ARM Mortgage Terms to Know
Understanding ARMs is a little easier if you are familiar with some key terms.
A mortgage index is a benchmark interest rate that fluctuates over time. This index is what the ARM is based upon. When the index rate moves, the rate on your variable-interest credit products will too.
Popular indexes include the London Interbank Offered Rate (LIBOR), the prime rate, and US Treasury securities.
This is the number of percentage points that a lender will add to the index rate for each adjustment period.
A cap is a limit to how much the monthly payment or interest rate can change. This can either be a cap on how much payments can rise per year or over the lifetime of the loan.
A conversion clause allows a borrower to convert their adjustable-rate mortgage to a fixed-rate loan at a future date.
Lenders will often allow you to buy down your initial rate offering using discount points. In other words, you can pay your lender upfront in exchange for a lower interest rate for a specified period of time.
After the discount period, the interest rate will likely increase, depending on the index rate.
How Rates for ARMs Are Determined
So how does all of this work together to give you your interest rate? It’s actually pretty simple!
Your interest rate is equal to the index rate plus the margin. The margin set in the loan agreement is the margin for the life of your loan. The only thing that changes over time is the index.
Types of Adjustable-Rate Mortgages
Not all ARMs are the same. There are three main types:
With an interest-only adjustable-rate mortgage, only interest payments will be due for the initial period of the loan. During this period, the borrower is not required to pay down any principal.
This period can be anywhere from several months to several years.
After the initial period, monthly payments will be adjusted so that the loan principal will be paid off by the end of the original term. This results in a substantially higher monthly payment.
A hybrid ARM has both a fixed-rate and adjustable-rate period. After the borrower pays a fixed rate for a specified period of time, the rate will be subject to periodic adjustments.
Payment option ARMs give you, as the name implies, payment options. These options typically include:
- Payments covering principal and interest
- Payments that pay down interest only during the intro period
- A minimum payment that doesn’t cover interest
Payment option ARMs offer great flexibility but can also cause borrowers to rack up even more debt— especially the minimum payment option. With this option, your debt may grow faster than you are able to pay it off, leaving you with a mountain of debt that far exceeds the original loan amount.
When to Use an Adjustable-Rate Mortgage
The term ‘adjustable rate mortgage’ conjures up memories from the 2008 financial crisis for some. It’s true— subprime adjustable-rate mortgages were among the major factors that contributed to the collapse of the housing and stock market, giving the loan product a bad reputation.
However, times have changed. The financial and banking industries operate with far more caution (and regulation) than they did in 2008. New laws and restrictions are in place to make ARMs more transparent and safer for borrowers than they were back then. Subprime mortgages are almost nonexistent, and the specific financial environment that made the Great Recession possible just isn’t our reality today.
Borrowers should consider the following pros and cons to determine whether taking out an ARM is right for them and their homebuying goals.
Lower payments initially: ARMs are known for their lower initial interest rate. This can save you money during the first few months or years of your loan. This makes ARMs especially lucrative if you think you may sell your home after only a couple of years.
Payments can increase: Many are lured towards an ARM with the low intro rate. However, some people forget to plan for the potential (and likely) payment increases.
If you don’t plan for these increases, your mortgage can become unaffordable.
Payments can potentially decrease: Borrowers are often concerned with how much their loan payments will increase. However, ARMs can also decrease. If index rates drop, you’ll benefit.
You may not sell when you anticipate: If you get an ARM in anticipation of selling before the rate rises, you may find yourself out of luck. Things don’t always go according to plan, meaning you can find yourself with a higher interest rate than you anticipated.
Rate and payment caps: Caps mean that your interest rate won’t continue to rise indefinitely. This safeguard helps ensure that you’ll be able to afford your payments, regardless of what happens to the index rate.
ARMs are complex: Although laws require lenders to be more transparent about their loans, ARMs are more complicated than fixed-rate loans. The fees, structures, and rules involved can be a little confusing for borrowers.
ARMs can be uncertain in the long run, but far more predictable in the short run. This means that if you know you are only going to be in your home for a few years, an adjustable rate may be the smartest move for you.
Compare Your Mortgage Options
Not sure what mortgage is right for you? Compare your options by talking to a local mortgage loan specialist at Amplify Credit Union. They can walk you through the different types of loans available so that you can weigh the pros and cons and make an informed decision.