6 minute read
August 3, 2022

What is the Advantage of an Adjustable Rate Mortgage?

What is the Advantage of an Adjustable Rate Mortgage?
6 minute read
·
August 3, 2022

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An adjustable-rate mortgage (ARM) is a popular type of mortgage available for first-time homebuyers and existing homeowners looking to refinance their current mortgage. 

As mortgage rates continue to rise, many home buyers are exploring adjustable-rate mortgages to finance their new homes. 

However, each mortgage product has advantages and disadvantages, and deciding which is the best for your family’s needs deserves careful consideration.

Understanding adjustable-rate mortgages (ARMs)

An adjustable-rate mortgage (ARM), sometimes called a “variable-rate mortgage” or an “adjustable-rate loan”, is a home loan that offers a set or “fixed” interest rate for a specified period of time, after which your interest rate adjusts periodically.

Adjustable-rate mortgages are available for various loan products, including FHA loans, VA home loans, VA IRRRL, or other refinance mortgage loans.

Mortgage lenders typically offer introductory interest rates for an adjustable-rate mortgage that is lower than fixed-rate mortgage interest rates. 

This can initially make an ARM more affordable compared to a fixed-rate mortgage for the same home loan amount. 

An adjustable-rate mortgage could save you money over your loan’s lifetime, for example, if interest rates drop or remain consistent during a portion of your loan’s lifetime.

Once your adjustable-rate mortgage’s initial fixed-rate period ends, your mortgage interest rate will adjust based on market activity. 

ARMs are adjusted according to certain indexes. Depending on which index your ARM uses, your monthly mortgage payment could go up or down.

The financial industry establishes and sets the indexes, which lenders then use to establish mortgage rates. 

Commonly used interest-rate indexes include the Federal Funds Rate, LIBOR (London Interbank Offered Rate), and the One Year Treasury rate.

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Advantages and disadvantages of adjustable rate mortgages

Adjustable-rate mortgages can be a great choice for some borrowers.

Advantages

  • Lower interest rates during the initial period compared to a fixed-rate mortgage
  • Borrowers can benefit when interest rates drop. Borrowers with an ARM experience a lower monthly payment when rates decrease
  • Lower interest rates for the introductory period allow borrowers to have an increased cash flow in their monthly budget and potentially put money aside for other uses—such as an emergency fund or college tuition

Disadvantages

  • Over the lifetime of a home loan, interest rates, and monthly mortgage payments can fluctuate or increase, making it difficult to budget or plan
  • Annual adjustment and lifetime rate caps limit how much a borrower’s interest can increase but may not apply to the first adjustment
  • Because of their complex nature and the variety of index rates, margins, and caps, it can be challenging to keep up with everything. If you opt for an ARM, it’s important to partner with a mortgage lender who is available and committed

Down payments

Down payment requirements for adjustable-rate mortgages are generally the same as fixed-rate mortgages. 

A minimum down payment totaling five percent of the home’s purchase price is typical. However, different loan types, such as FHA or VA loans, offer borrowers lower down payment options.

Types of ARM loans

ARMs commonly come in three types of loans:

  • Hybrid
  • Interest-only (IO)
  • Payment option 

Hybrid adjustable-rate mortgage 

A Hybrid ARM combines a fixed-rate period of time and an adjustable-rate period of time. 

With a hybrid ARM, borrowers have a fixed interest rate for their loan’s initial or introductory period. After this initial period ends, the interest rate begins to adjust. 

Hybrid ARMs are usually written as two numbers, with the first number representing the fixed-rate period and the second number referring to the adjustment period. 

For example, a 5/5 ARM has a five-year fixed period, followed by a variable rate that adjusts every five years. 

A 5/1 ARM has a five-year fixed period and adjusts annually once that initial five-year period is over. 

Interest-only (IO) adjustable-rate mortgage

An interest-only (IO) ARM offers borrowers the opportunity to pay only interest on their mortgage for a period—usually between three and ten years. 

Once the interest-only period ends, borrowers must pay both interest and principal on their home loan. An IO ARM can be beneficial for borrowers who want to free up money during the early years of their mortgage. 

However, it’s important to remember that the longer the interest-only period, the larger the monthly mortgage payments will be later.

Payment option adjustable-rate mortgage 

A payment-option ARM offers borrowers several payment options, including:

  • Principal and interest
  • Interest-only
  • A set “minimum” amount that does not fully cover the interest

Each of these payment options provides borrowers to establish a payment structure that works best for their financial situation and personal goals. 

Regardless of your payment option, the mortgage loan must be repaid on time by the payment date specified in your loan terms. 

Paying the smallest monthly payment today may not be the right choice for every home buyer, as it can lead to larger payments in the future.

Is an adjustable-rate mortgage right for you?

One of the popular advantages of ARMs is the low initial interest rate, making it easier for some borrowers to qualify for the loan and to afford the monthly payments. 

Lower rates might also help borrowers purchase a more expensive home that would be out of range with a fixed-rate loan. 

Additionally, an ARM might be a good option if you’re in a high-price area or considering a jumbo loan.

Before deciding on whether an ARM is right for you, ask yourself a few questions:

  1. How much can I afford to pay for a monthly mortgage payment?
  2. Will I be able to afford my ARM if interest rates increase after the initial period?

Get in touch with Assist Home Loans to guide you through your pre-approval process

If you’re serious about finding your dream home, connect with the trusted mortgage loan officers at Assist Home Loans and get pre-approved for a home loan.

We’re here to guide you through the mortgage pre-approval process and help your offer to buy stand out.

Let us put our expertise to work for you—get in touch with Assist Home Loans today.

Photo by RODNAE Productions

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