Understanding Adjustable Rate Mortgages (ARMs)
There are two types of conventional mortgages: fixed and adjustable rate mortgages. Fixed rate mortgages have an interest rate that remains the same for the entire term of the loan whereas adjustable rate mortgages, also known as ARMs, have a rate that changes.
As adjustable rate mortgage loans have interest rates that can be more complex to understand, you will find here what you need to know about this type of loan product, the terminology used to describe them, the different types of ARMs, and the risks and benefits associated with choosing an ARM instead of a fixed rate mortgage.
What is an Adjustable Rate Mortgage?
Let's start with a basic explanation of what an ARM loan is and how it works. Simply stated, an adjustable rate mortgage is a mortgage with an interest rate that changes. Many adjustable rate mortgage terms begin with a fixed rate period during which the interest rate does not change. After this fixed rate period ends, your rate and mortgage payment will change and could increase based on the terms and conditions of the loan.
We'll talk more about the benefits and risks of adjustable rate mortgages later in this post.
Adjustable Rate Mortgage Terms to Understand
Now that you know what an adjustable rate mortgage loan is, let's review some key terms that you should understand. These terms will be specified in your Loan Estimate and in other loan documents.
Initial Rate and Payment
The initial rate and payment refers to the interest rate and monthly payment in place at the inception of your ARM loan. The initial rate will remain the same for a period of time and then will adjust based on the specifics of your loan.
Some ARM programs you may see are the 7/1, 5/6, and 7/6. The first number indicates the fixed rate period, and the second number indicates the adjustment period.
The adjustment period of an ARM indicates when the ARM rate is subject to change. Some ARMs have an adjustment each year after the initial fixed rate term. A more frequent adjustment period means you will see your rate change more often.
For example, a 7/1 ARM would have a seven-year fixed period followed by interest rate adjustments that would occur every year for the remaining term of the loan. A 7/6 ARM would have a seven-year fixed period followed by interest rate adjustments that would occur every six months for the remaining term of the loan.
An index is a measure of interest rates based on what is going on in the market and the condition of the economy, and it can fluctuate. There are multiple indexes a lender can choose from when calculating interest rates, but a few of the most common indexes are the U.S. prime rate, Secured Overnight Financing Rate (SOFR), and the Cost of Funds Index (COFI). The index will determine how your interest rate changes after the initial fixed period has ended.
The margin is a fixed percentage rate that will be set by your lender. The index plus the margin determines your adjusted interest rate, which is referred to as the fully indexed rate.
Interest Rate Caps
An interest cap limits the amount that your ARM rate can increase. There are two types of caps you should know about.
A periodic adjustment cap limits the amount your interest rate can increase or decrease from one adjustment period to the next after the initial period.
Benefits Associated with Adjustable Rate Mortgages
One benefit of an ARM loan is that it could allow you to save money on interest in the first few years of a mortgage. That's particularly true for someone who knows they aren't planning to stay in a house long term. For example, if you know that you will be moving frequently due to job changes, you could have lower payments with an ARM loan versus a fixed rate mortgage.
Another benefit would be if you know you are selling another home in the future and could use that equity to pay off your adjustable rate mortgage in the initial fixed period.
Rate and Payment Caps
After the initial fixed rate period ends on an ARM loan, there will be limits on how much your rate can increase. If rates decrease, you could have an even lower payment in the future which allows you to take advantage of falling rates without the cost of refinancing.
Risks Associated with Adjustable Rate Mortgages
Rising Monthly Payments/Payment Shock
The first risk you should consider is probably obvious by now. When you take out an adjustable rate mortgage, your interest rate is likely to rise and with it, your monthly mortgage payment.
It's important to understand the frequency of adjustment periods and the interest rate caps before you sign on the dotted line. Otherwise, you could end up with a payment you can't afford. Consider your future expenses – will you have medical needs, job, or school changes in the upcoming future? A higher mortgage payment may not be the best option.
For many homeowners, refinancing a mortgage can be an ideal way to reduce monthly payments, get a lower interest rate, or get the cash they need to remodel. However, with an ARM, sometimes refinancing can be tricky. Depending on property values, you may not have as much equity in your home as you would need to refinance.
Another item to consider in refinancing your home is that the closing costs will be your responsibility and should be discussed with your mortgage lender.
Prepayment Penalties Associated with Refinancing
A prepayment penalty is a fee that some lenders charge if you pay off all or part of your mortgage early. Not all mortgages have a prepayment penalty. It is recommended that you refer to your loan documentation and talk to your lender to determine if your mortgage does or will contain a prepayment penalty clause that could affect refinancing. If a loan you are considering has a prepayment penalty, make sure to read the fine print carefully so that you understand exactly the circumstances under which you have to pay, and how much. Make sure you understand the penalties before you choose an ARM, especially if your intention is to refinance before the fixed period is over.
Adjustable rate mortgages can be beneficial to you as a borrower, provided you understand both the risks and benefits. Always ask your lender about features of the ARM programs being offered so you are able to make the best financial decision for your current and future financial circumstances.
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