Mortgage shopping involves a lot of choices, and one of the big ones is whether you want an adjustable rate mortgage or a fixed rate mortgage. Of those two options, adjustable rate mortgages are often the more confusing and complicated, with more details to keep track of.
Here, we'll cover what an adjustable-rate mortgage is and discuss some factors that determine the rate on this type of home loan. We'll also compare fixed vs. adjustable rate mortgages and see some of the pros and cons of an adjustable rate.
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can go up or down, depending on what mortgage interest rates are like in the economy as a whole. The interest rate changes on a schedule that's set ahead of time. Typically, there are a few restrictions on how much the rate can rise or fall.
An ARM has an initial period when the rate is fixed, followed by adjustment periods. The interest rate changes once for every adjustment period.
ARMs are often advertised with a combination of two numbers, like 3/1 or 5/1, which tell you how long the initial period and the adjustment period will be. For example, a 5/1 ARM has an initial period of five years and adjusts once per year after that. Sometimes, though, one of these numbers will indicate years while the other refers to months, like a 5/6 ARM that has a five-year initial period and a six-month adjustment period.
ARMs with long initial periods are sometimes called hybrids because they're like a fixed rate loan (the initial period) paired with an adjustable rate loan.
When you take out an ARM, you start off paying off your mortgage at the initial rate that was advertised to you. This rate is in place for a set period of time, which can be between six months and 10 years.
After that initial period, things get more complex.
How much your rate rises and falls with each adjustment depends on the features of your loan. Let's go over the basics.
Your interest rate is made up of two main parts: the index and the margin.
The index is a number that's updated frequently based on interest rates throughout the economy. It's like an average of the interest rates that several banks are currently charging — although the math that goes into it is a little more complex.
The margin is an amount that the lender adds to the index to get your interest rate. It appears in your loan estimate, so you know what it will be before you choose a loan.
Your interest rate equals the index plus the margin. For example, let's say it's time for a rate adjustment and the index is at 5.5%. If the margin is 2%, then 5.5% + 2% = 7.5%, so your interest rate is 7.5%.
The index and margin aren't the whole story. ARMs also have rate caps that protect you in case the index soars. A rate cap sets a maximum amount that your interest rate can rise.
ARMs are generally required to have a lifetime cap, which restricts how much the rate can go up over the course of the loan. This is often 5%. So if your lifetime cap is 5% and you start out with an interest rate of 4%, then your rate on the loan can't ever go higher than 9%.
And some ARMs have adjustment caps that keep the rate from climbing by more than a certain amount at each rate change. Often, there's a cap on the first adjustment of 2% to 5%, and a cap of around 2% on all the remaining adjustments.
Some ARMs allow the lender to save the part of an interest rate increase that's not applied because of a rate cap and apply it to the next adjustment instead. For example, if the index goes up by 4% and you have an adjustment cap of 2%, then your rate only goes up by 2% for that adjustment period. But the remaining 2% carries over. So even if the index doesn't go up at all by the next adjustment, your rate is still due to rise another 2%.
ARMs can have floor rates that prevent the interest rate from falling below a specified level. Even if the sum of the index and margin drops lower, the rate can't fall beneath this minimum. That's not great for the borrower because it means you don't get to take full advantage of a big decline in interest rates.
It's also possible for an ARM to be set up so that the interest rate can only rise or stay the same and can't go down. A loan with this structure could be quite a bit more expensive than a loan where the rate can drop.
Typically, you get a new payment amount each time the interest rate adjusts, although for some loans the payment is calculated less often.
An ARM may have a payment cap that limits how much the payment can rise at one time. That could be in addition to an adjustment cap, or a loan could have a payment cap but no cap on how much the rate rises for each adjustment period.
Some ARMs give you a choice about how much to pay and are known as payment-option ARMs. Instead of making a payment that covers both your principal and interest, you might be allowed to pay just the interest or a portion of the interest.
If your payment isn't large enough to cover all the interest you're charged, the balance on your loan goes up. That's known as negative amortization.
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There are some major differences between fixed rate mortgages and adjustable rate mortgages. Here's how they compare.
ARMs have the potential to save you money, but they come with risks, too.
The initial rate on an ARM will often be lower than the rate on a fixed rate mortgage. So if you want to move or refinance in the short term, it could be cheaper to get an ARM and pay it off before the introductory period is over.
If you get an ARM that doesn't have a high floor rate, the fact that your rate can drop is an advantage. If rates fall, you could score a lower payment without going through the trouble of refinancing.
An ARM could also be less expensive than a fixed rate mortgage over the life of the loan if interest rates stay about the same or decrease.
And because ARMs offer so many possible choices, like different rate caps, payment caps, and payment options, you might be able to shop around and find just the mix of features you want.
On the other hand, the rate on an ARM can rise, which could make your payments less affordable. And if your rate adjusts upward and stays high, you could end up paying more in interest than you would have with a fixed rate mortgage.
The changing rates and payment amounts make it tricky to forecast what your payments will be in the future, so it's harder to budget for an ARM. It can also be difficult to guess how much an ARM will cost you in total.
Plus, ARMs are more complicated than fixed rate mortgages. It can be challenging to make an apples-to-apples comparison between loans when they have different rate caps or adjustment periods.
And for ARMs that allow negative amortization, the potential for your balance to grow is a big risk. Instead of making progress paying down your loan, you could find yourself owing more money than you bargained for.
Related: How does an interest-only mortgage work?
An ARM could be a good choice if you're buying a home that you plan to stay in for just a few years. You could enjoy the low initial rate for a time, then move before a rate increase kicks in — assuming you're able to sell when you planned to.
If you expect interest rates to fall in the future, you might save money with an ARM if it allows the rate you're paying to decrease too.
And in general, an ARM will make more sense for someone who's doing well financially and has some wiggle room in their budget. If you can easily handle a higher payment, then the risk that your rate might rise won't be as much of a concern.
It can be tempting to focus on the rosiest possibilities when you consider an ARM. But to make a good decision, you need to pay attention to the worst-case scenarios, too. Look at the maximum interest rate you could be charged and the maximum payment you might owe, and ask yourself if you're okay with them. And as always, it's smart to run your options by an expert like an HUD-approved housing counselor or an attorney before selecting a loan.
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