Takeaways
- ARMs can be great options to first time home buyers who need access to financing.
- ARMs have interest rates comprised of an index rate plus a fixed margin.
- ARMs can have lower interest rates during the initial term, resulting in savings in the early years.
- ARMs can increase your monthly mortgage payment significantly if interest rates rise quickly.
- ARMs lack predictability, make financial planning more challenging, and may include prepayment penalties that negate initial savings
Thinking about buying your first home? Getting the right type of mortgage is one of the most stressful parts of the home-buying process for many homeowners. But it doesn’t have to be. It is essential to research mortgage types, costs, and structures to help become prepared for one of the largest purchases of your life.
In the world of home financing, having a clear understanding of the various mortgage options available to you is critical. Every mortgage type has a unique set of benefits and potential drawbacks for the homeowner, so they should be considered heavily before deciding on any mortgage type. Today, we’re going to look at a type of mortgage that is well-known, but not well-understood, the adjustable-rate mortgage, or ARM. We’ll look at how they work and when you may want to consider choosing one. Let’s get to it.
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What is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM) is a specific type of home loan where the interest rate can change over time, often after an initial period where it’s locked. The adjustable-rate mortgage differs considerably from a fixed-rate mortgage, where the interest rate stays the same for the life of the loan.
The interest rate of an ARM is determined by two factors. The first is a specific index, Secured Overnight Financing Rate (SOFR), and the second is the additional margin charged by the lender. This rate adjustment, often occurring annually, can lead to significant changes in the monthly mortgage payment, making adjustable-rate mortgages far more unpredictable than fixed-rate mortgages.
How Does an ARM Work?
Typically, an adjustable-rate mortgage starts with an initial fixed interest period, known as the “initial term”, which is usually 5, 7, or 10 years. During this time, your monthly payments remain stable because the rate will not change. However, after the initial term is over the interest rate is subject to regular adjustments. Adjustments are usually made annually.
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The new rate is calculated based on the index rate plus an additional margin. The index rate is the standard rate that reflects the general lending market conditions and can vary over time, while the markup will be constant throughout the life of the loan. The change in the interest rate will cause your monthly payment to fluctuate year to year, but the changes will often be limited to a maximum degree of adjustment from one year to the next, as well as for the lifetime of the loan.
For example, you could have a 3% SOFR plus a 4% markup this year, bringing your total interest rate payment to 7%. On the annual reset, the SOFR could rise to 6% and your 4% markup stays consistent. This brings your interest rate payment to 10%.
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Advantages of Adjustable-Rate Mortgages
Lower Initial Rates: ARMs typically offer lower interest rates during the initial term compared to fixed-rate mortgages. This could translate into significant savings in the early years of homeownership.
Benefit from Falling Rates: If market interest rates decrease, so will your ARM rate after the initial fixed period, resulting in lower monthly payments without needing to refinance.
Afford More Home: The lower initial interest rate might enable you to qualify for a larger loan, thus affording a more expensive house.
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Disadvantages of Adjustable-Rate Mortgages
Uncertainty: ARMs lack the predictability of a fixed-rate mortgage—your monthly payments could fluctuate over time, making financial planning more challenging.
Complexity: ARMs come with more complex terms and conditions, such as adjustment frequency, rate caps, and indexes, which can confuse some borrowers.
Prepayment Penalties: Some ARMs include a prepayment penalty, meaning you'd have to pay a fee if you pay off the mortgage early, which could negate the savings from lower initial rates.
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When You Might Want an ARM
Choosing an adjustable-rate mortgage is a highly strategic decision that takes considerable planning and a little luck but can result in significant savings over the life of the loan or the ownership period of the home. Here are some situations where you might want an adjustable-rate mortgage.
Short-term homeownership: If you plan to sell your home before the initial fixed-rate period ends, you can take advantage of lower initial interest rates offered by adjustable-rate mortgages.
The expectation of rising income: If you anticipate a future increase in your income, you might be able to afford higher mortgage payments even when the rate adjusts.
Lower initial payments: If the initial lower payments are vital for your current financial situation, an adjustable-rate mortgage could be a viable choice.
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Smart Summary
For those about to enter the real estate market, understanding adjustable-rate mortgages is an essential part of finding the best financing deal. Evaluating your unique circumstances, financial goals, and risk tolerance will guide your decision-making process. Remember, the goal is to choose a mortgage that aligns with your long-term financial plan, providing stability and affordability.
