When it comes to purchasing a new home, the loan options can be overwhelming. You’ll hear terms like, FHA, conventional, fixed, adjustable, and many other buzzwords that may make your heads spin, but fret not! We are here to help you navigate the home buying waters. If an adjustable-rate mortgage is on your consideration list, here are a few things you need to know.
What is an Adjustable Rate Mortgage?
An adjustable-rate mortgage, or ARM, is a mortgage with a varying interest rate. This interest rate can change or adjust throughout the life of a loan. An ARM differs from a fixed-rate mortgage in that a fixed-rate mortgage’s interest rate stays the same or is fixed throughout the life of a loan.
Three Basic Principles of an ARM:
1. Initial Period
An ARM typically starts with an initial, fixed rate. This initial rate can be significantly less than the rate of a fixed rate mortgage, or FRM. However, the ARM’s initial rate will only stay at its low rate for a certain period of time. This period of time is called the initial period. The initial period can range from as little as one month to as long as ten years. After the initial period ends, the rate will adjust.
2. Adjustment Period
After the initial period ends, the loan enters into the adjustment period. In the adjustment period, the rate and monthly payment change periodically. The rate adjusts depending on the index and the margin. The index is an interest rate set by the market, so it varies depending on market conditions. The margin, on the other hand, is constant and is set by the lender.
ARMs do have caps, which means there’s a set limit on how high your interest rate can increase. Your ARM can either have an initial, periodic, or lifetime cap. An initial cap limits the amount the interest rate can adjust when moving into the initial adjustment period. A periodic cap limits the amount the interest rate can adjust when moving from one adjustment period to another. A lifetime cap limits the amount the interest rate can adjust for the entire lifetime of the loan.
Why Choose an ARM?
Lower Initial Payment
During the initial period of an ARM, the loan interest rate is typically lower than that of a fixed rate mortgage. To see how much you'd be able to save with an adjustable rate mortgage versus that of a fixed, simply calculate how much a fixed rate mortgage would be for the length of the initial period and then calculate how much an adjustable-rate mortgage would be for the length of the initial period. Subtract the adjustable rate's sum from the fixed rate's sum, and you'll be able to see your savings. Taking advantage of this low rate during the initial period could significantly increase your financial savings and is a big reason why some homeowners choose to go with an adjustable rate mortgage.
Higher Valued Home
Choosing an ARM can allow you to obtain a higher loan amount and thus a more valuable house. A lot of people take advantage of an ARM in order to purchase a higher valued house, and then refinance the loan after the initial period. Keep in mind, there are fees associated with refinancing, so it’s critical to consult a loan officer to help you determine if this is the best option for you and your family.
Length of Stay in Home
How long do you plan on staying in the home? If you know you plan on moving again soon, then a 30-year fixed rate loan may not be your best option. Instead, take into consideration how long the initial period would be on an ARM. For example, if your initial period ends after five years, and you know you plan to move after those five years, it may be beneficial to get an ARM, take advantage of its initial period rate, and then sell the home.
When assessing whether it’s worth it to choose an adjustable rate mortgage, remember to consider all of your options, and consult with a seasoned mortgage loan officer that can help you find the best loan option for you and your family.