When it comes to financing a home, there are many options available to borrowers. One of these options is an adjustable-rate mortgage (ARM). In this blog post, we’ll explore what an ARM is, how it works, and the pros and cons of this type of loan.
What is an ARM?
An ARM is a type of mortgage in which the interest rate can fluctuate over the life of the loan. Typically, the interest rate is fixed for an initial period (usually 5, 7, or 10 years), and then it adjusts annually based on a predetermined index, such as the London Interbank Offered Rate (LIBOR) or the Constant Maturity Treasury (CMT) rate. The interest rate can go up or down based on changes in the index, which means your monthly mortgage payments can also fluctuate.
Types of ARM
- 3/1 ARM
- 5/1 ARM
- 7/1 ARM
- 10/1 ARM
How does an ARM work?
Let’s say you take out a 7/1 ARM. This means that the interest rate is fixed for the first 7 years of the loan, and then it adjusts annually for the remaining 23 years (assuming a 30-year mortgage). The initial interest rate on the loan is typically lower than that of a fixed-rate mortgage, which is one of the primary benefits of an ARM.
After the initial period, the interest rate on the ARM is reset annually based on the index and a margin, which is a percentage added to the index rate to determine the new interest rate. For example, if the index rate is 2% and the margin is 2%, your new interest rate would be 4%.
Caps of an ARM
- Periodic Adjustment Cap
- Lifetime Adjustment Cap
- Initial Adjustment Cap
- Payment Cap
Pros and cons of an ARM
Like any financial product, there are pros and cons to getting an ARM.
Pros:
- Lower initial interest rate: As mentioned earlier, the initial interest rate on an ARM is typically lower than that of a fixed-rate mortgage. This can save you money on your monthly mortgage payments, especially if you plan to sell the home before the interest rate adjusts.
- Flexibility: If you don’t plan on living in the home for the entire life of the loan, an ARM can be a good option. You can take advantage of the lower initial interest rate and then sell the home before the interest rate adjusts.
- Potential savings: If interest rates go down, you could end up with a lower interest rate and lower monthly mortgage payments.
Cons:
- Uncertainty: The biggest downside of an ARM is the uncertainty of future interest rates. If interest rates go up, your monthly mortgage payments could increase significantly, making it harder to afford the home.
- Complexity: The adjustable interest rate and annual adjustments can make an ARM more complex than a fixed-rate mortgage, which can make it harder for borrowers to understand.
Is an ARM right for you?
In conclusion, an ARM can be a good option for some borrowers, especially those who plan to sell the home before the interest rate adjusts. However, it’s important to consider the potential risks of an ARM and make sure you can afford the maximum possible monthly payment before deciding to get this type of loan. As always, it’s important to work with a qualified mortgage professional to determine which type of loan is right for you.
FAQs
1. Should I get an ARM or a fixed-rate mortgage?
The decision between an ARM and a fixed-rate mortgage depends on your personal financial situation and goals. If you’re planning to stay in your home for a long time, a fixed-rate mortgage might be the better option since you’ll have a predictable payment amount. However, if you’re planning to sell your home before the interest rate adjusts, an ARM might be a better option since you can take advantage of the lower initial interest rate.
2. How often does the interest rate adjust on an ARM?
The interest rate on an ARM adjusts annually after the initial fixed-rate period. The exact date of the adjustment varies depending on the terms of the loan.
3. What is the difference between an ARM and a hybrid ARM?
A hybrid ARM is a type of ARM that has a fixed interest rate for a certain period of time, followed by an adjustable interest rate. For example, a 5/1 hybrid ARM has a fixed interest rate for the first 5 years, and then the interest rate adjusts annually.
4. Can I refinance my ARM to a fixed-rate mortgage?
Yes, you can refinance your ARM to a fixed-rate mortgage if you want to. However, you’ll need to meet the lender’s qualifications for a new mortgage, including credit score, income, and debt-to-income ratio.
5. Are there any penalties for paying off an ARM early?
It depends on the terms of the loan. Some lenders charge prepayment penalties if you pay off an ARM early, while others don’t. Be sure to read the terms of your loan carefully to understand any potential penalties.
Final Thoughts
Adjustable-rate mortgages (ARMs) can be a good option for some borrowers, but they come with certain risks and uncertainties. If you’re considering an ARM, it’s important to understand how it works and the potential benefits and drawbacks. Work with a qualified mortgage professional to determine whether an ARM is the right choice for your financial situation and goals.
