When purchasing a home, you have the option to get either a fixed-rate or adjustable-rate mortgage. Your income, your plans for the future, and how long you plan on taking to pay off your mortgage all affect which type is best for you. Here, we explain adjustable-rate mortgages, their pros and cons, and who they’re best for.
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What is an ARM?
ARM stands for adjustable-rate mortgage. Depending on the type of ARM you get, you will get a fixed interest rate on your mortgage for the first three to seven years. After that, the interest rate will fluctuate according to market rates.
When rates are low, this can be very good. But when the markets aren’t favorable and the rates are high, your payments will rise to reflect that.
A fixed-rate mortgage, on the other hand, has the same interest rate for the entire life of the loan. Some people prefer this kind of stability. However, some will benefit from the structure of an ARM. It all depends on your specific financial situation and your goals.
Pros and Cons of an Adjustable-rate Mortgage
You could end up paying less total interest.
A fixed-rate mortgage locks in a specific rate for the life of the loan. Since an ARM changes rates, your interest rate could be lower than what your fixed rate would be. This means you’ll pay less total interest in the end.
There are caps on rates and payments.
A changing rate may make you nervous, but the adjustment cap and ceiling ensure that high market rates can only affect your own rate to a certain degree.
It could be hard to sell or refinance when you want to.
ARMs come with more complicated rules and restrictions than fixed-rate mortgages. When deciding to sell your home or refinance, a fixed-rate mortgage gives you more freedom.
You could end up paying more.
Yes, we said you could end up paying less than with a fixed-rate loan. But you could also end up paying more depending on how the market rates rise.
The rules are complex.
A fixed-rate mortgage is simple. You have one rate to worry about, and that’s basically the extent of the rules. ARMs are much more difficult to understand. Your rates change according to multiple factors, and your payments change too. This can be stressful if you’re the kind of person who likes consistency.
ARMs sometimes have a prepayment penalty.
If you have the money to make larger payments than necessary to pay off your loan sooner, you may have to pay a penalty fee if you have an ARM.
Compare rates before you Purchase or Refinance.
This term describes how often your interest rate is adjusted after your initial fixed-rate period is o
ver. Usually, rates adjust yearly.
Lenders use an adjustment index to determine how much your new interest rate will be.
Interest rates are tied to a specific index, such as LIBOR (London Interbank Offer Rate) or Cost of Funds Index.
This is the percentage above the adjustment index that you agree to pay.
During an adjustment period, your interest rate can only increase by a certain amount. This is called the cap. If the difference between the market rate and your current rate is higher than the cap, then your rate will only rise to the cap.
There are two different types of interest rate caps. One lasts for the life of the loan and one limits the amount your rate can increase within one adjustment period.
The highest an adjustable rate can get over the life of the loan. Even if the market rate is higher, the rate on your loan can’t go past this percentage.
Most ARMs require the homeowner to only borrow a certain amount. The typical limit is $510,400.
The higher your credit score, the lower your interest rates will be. If you have a low credit score, the fixed rate you have in a hybrid ARM may be higher than in a fixed-rate mortgage.
For an ARM, you can make a down payment as low as 5%, but you’ll want to do at least 20% if you want to avoid paying PMI (private mortgage insurance).
Types of ARMs
There are a few different types of adjustable-rate mortgages. The first is a 1-year ARM, which is the simplest. Its interest rate adjusts annually. There are also 3-year ARMs, which adjust every three years and 5-year ARMs, where the rate adjusts every five years.
Next up are hybrid ARMs, which are the most popular. Their names all have a similar structure, starting with a number over one. The first number tells you how long the loan will have a fixed rate before switching to an adjustable rate. The one denotes that the rate will adjust annually.
- 3/1 ARM: A hybrid adjustable-rate mortgage with a fixed rate for the first three years. Then the interest rate adjusts annually.
- 5/1 ARM 7/1 ARM: A hybrid adjustable-rate mortgage with a fixed rate for the first five years. Then the interest rate adjusts annually.
- 10/1 ARM: A hybrid adjustable-rate mortgage with a fixed rate for the first ten years. Then the interest rate adjusts annually.
There are also hybrid ARMs for 2/28 and 3/37. These loans have a fixed rate for 2 and three years respectively, then the rates adjust for the remaining 28 or 27 years. Rate adjustments can happen every six months with these types of ARMs.
Also called a payment-option ARM, an option ARM gives you a few different ways to pay. Some of those options won’t cover the full amount of the mortgage loan, so plan wisely.
- Pay down your principal and your interest. This is the only choice that will help you pay down what you owe.
- Pay only toward your interest. This will help you get rid of some interest charges, but won’t pay down your loan.
- Pay an amount that doesn’t even cover your interest. This will actually increase what you owe.
Usually, every monthly mortgage payment covers part of the interest and part of the principal because that’s the only way to actually reduce what you owe. The option ARM allows you to make smaller payments, but at the expense of paying down less of your principal – or adding to what you owe.
VA and FHA ARMs
An ARM from the Federal Housing Administration (FHA) is backed by the government. Keep in mind that FHA loans always have PMI, regardless of how much you put down as a down payment.
Candidates for ARMs
Adjustable-rate mortgages aren’t for everyone, especially those who aren’t sure if they could handle a rising mortgage payment.
An ARM may be right for you if…
You’re moving soon.
You can lock in a low rate for several years and move before the rate starts fluctuating. Those only living in a home for a few years before selling can take advantage of lower rates.
You’re paying off the whole loan soon.
You won’t have to worry about unpredictable rate changes if you are paying off the entire loan within the next several years.
You’ll make more money soon.
Expecting a raise? A higher income will make it easier to prepare for fluctuating rates. If you’re getting a new job soon or know you’re getting a raise, you may be able to better handle an ARM.
Article last modified on December 17, 2020. Published by Debt.com, LLC