What is an adjustable rate mortgage?
An adjustable rate mortgage, or ARM, has a mortgage rate that is not fixed. Instead, the rate fluctuates according to prevailing market for interest rates overall.
This makes adjustable rate mortgages somewhat unpredictable. Compared to a fixed-rate mortgage, where the interest rate remains unchanged, the rate you pay may rise or fall significantly over the life of the loan.
On the other hand, adjustable mortgage rates start out significantly lower than those on fixed-rate mortgages, so you can save a lot of money if rates remain stable or even decline while you have your loan.
An adjustable rate mortgage is an option on most types of home loans, where you can choose it instead of a fixed rate if you wish. However, they're a mandatory feature on some mortgage types, such as a home equity line of credit (HELOC), which are adjustable rate loans during the draw period, during which you can borrow money.
Adjustable rate mortgages have a preset pattern that determines when the rate can adjust. On most home purchase or refinance loans, the initial rate is fixed for a period of one to 10 years, and only after that begins to adjust to reflect market trends, usually once a year.
For example, one of the most common types of ARMs starts out with a fixed rate for the first five years, then adjusts every year after that. This is known as a 5/1 adjustable rate mortgage. Another common type is the 7/1 adjustable rate mortgage, which is fixed for the first seven years and then adjusts every year from then on.
What are the advantages of an adjustable rate mortgage?
Because adjustable mortgage rates start out lower than fixed rates, your monthly payments are lower as well. This not only saves you money but may enable you to borrow more than you could with a fixed-rate mortgage.
The concern, of course, is that if market rates increase, adjustable mortgage rates will rise as well. But remember – on home purchase loans, most adjustable rate mortgages give you the option of locking in your initial rate for one to 10 years before the rate can adjust.
The typical homeowner only stays in a home for 5-7 years before moving on. So if that's what you expect to do, an adjustable rate mortgage can let you lock in a lower rate for the years you'll actually live there, rather than paying a higher rate for a 30-year fixed. By the time the loan starts to adjust, you'll have moved on.
As noted above, on some types of loans, such as HELOCs, an adjustable rate loan is your only option. With a HELOC, this is because lenders don't know how much of your line of credit you may use and when, and so wants to be able to charge a market-based rate at the time you take out the money.
How does an adjustable-rate mortgage work?
An adjustable-rate mortgage will have established rules spelling out when rates can change. Most will also have limits on how much a rate can increase at any one time and over the life of the loan. These will be specified in the loan documents and should be well-understood by the borrower before closing the loan.
The variations in the interest rate on an adjustable rate mortgage will be determined by one or a combination of indexes, which reflect underlying interest rates in financial markets overall. The adjustable rate will be a combination of the index and a margin, the latter a fixed number such as 2 or 3 percentage points that is added onto the index to get the adjustable rate. So if the index is at 2.5 percent and the margin is 2 percent, the adjusted rate would be 4.5 percent.
Some of the more commonly used indexes are:
- Treasury notes and bills
- The Federal Housing Finance Boards National Average mortgage rate, which is an average rate for loans closed.
- The average interest rate paid on jumbo certificates for deposit.
A lender may also use their own index based on their own actual borrowing costs to obtain funds.
Many of these indices are published in newspapers, financial web sites and online news services. Before going for an adjustable rate mortgage, check where you can find the published adjustments, if there are any types of sources for projections, and where the underlying index on which the adjustable rate is based is posted.
It goes without saying that the interest rates can go up or down. Therefore this type of mortgage loan can be a very viable option for people who are not too sensitive to fluctuating financing costs. Shopping for an adjustable rate mortgage can be more difficult than shopping for a fixed rate mortgage.
The fine print of an adjustable mortgage loan
It is important that you study the details of the loan; below you find some of the basics and terminology explained. In summary when looking at an adjustable mortgage rate you should consider in addition to basic rate and index information:
- Initial rates
- Adjustment intervals
- Rate caps and payment caps
Initial rate or teaser rate
The initial rate you are charged on the loan is generally lower than current interest rate. This can be an excellent way of purchasing a home you may not be able to get a fixed rate loan for, as the initial payments will be lower. As mentioned, when the bank is deciding how large of a mortgage you qualify for they base this on the monthly payments you can afford each month. Therefore a low initial rate on an adjustable rate mortgage can help you qualify for this type of loan but not for a fixed rate mortgage.
At the end of the initial rate term your interest rate will be based on the indexes specific for your loan. This index (or indices) is not the actual percentage interest rate you will be paying, but rather the basis on which they are calculated. In most cases some sort of a margin must be added to this to give the actual interest rate. This margin may vary. The index plus the margin will give the actual adjustable rate that the interest defaults to after the initial term.
Interval of adjustment
Be sure to ask for and understand the interval of adjustment for you mortgage. If the interval is one year, then the interest rate for the mortgage remain the same for one year and then changes in accordance with the index (and the margin). The mortgage rate will continue to adjust for the entire term of the mortgage.
Rate cap and payment cap
Besides margin and adjustment intervals, be sure to find out everything about rate caps. A rate cap is the maximum percent increase that can occur at each interval of adjustment. A payment cap is the maximum amount that your payment can go up at each adjustment interval.
What rates can you get on an adjustable rate loan?
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