Adjustable-Rate Mortgages (ARMs)
Flexible Financing for Dynamic Markets
Understanding Adjustable-Rate Mortgages
Adjustable-Rate Mortgages (ARMs) offer a different choice to the traditional fixed-rate mortgage. Over the life of the loan, they offer a period of stable, predictable payments. But this upfront savings comes with the potential for future cost changes down the road. For many borrowers, ARMs offer an opportunity to start with a lower starting interest rate and monthly payment. This can help make home ownership more affordable in the short term. That said, it's important to understand how these loans work.
At SRK CAPITAL, we know that there is a lot of uncertainty when it comes to adjustable-rate mortgages. It is important that those interested in an ARM know the different factors that influence future rate adjustments. That way you can decide if this type of loan aligns with your long-term financial goals. Here's what you need to know about the structure, benefits, and potential drawbacks of adjustable-rate mortgages.
Ready to Learn More?
Our team can help you understand if an adjustable-rate mortgage is right for your situation.
What is an Adjustable Rate Mortgage (ARM)?
An adjustable rate mortgage (ARM), can also be called a variable rate mortgage or hybrid ARM. An ARM is a home loan with an interest rate that adjusts over time based on the bond market. ARMs typically have a lower starting interest rate than fixed rate mortgages. That makes ARMs a potential money-saving choice if you want what has typically the lowest mortgage rate from the start.
The low starting interest rate won't last forever, though. Once that period ends, your monthly payment can fluctuate periodically. This makes your future monthly mortgage payments unpredictable and harder to factor into your budget.
Important: Taking time upfront to understand how ARM loans work can help prepare you if your rate starts to climb.
Comparing ARMs vs Fixed-Rate Loans
Potential home buyers often face a choice between an adjustable rate mortgage and a fixed rate mortgage. Choosing between an adjustable-rate mortgage and a fixed-rate mortgage depends on your financial situation and future plans. But what's the difference between the two?
Adjustable-Rate Mortgage
An ARM typically offers a lower starting rate during its introductory period than a fixed-rate mortgage. This means an ARM will give you lower monthly mortgage payments at the start of the loan. After the first period, changing interest rates will impact your monthly payment. When interest rates go down, ARMs can get cheaper. But if rates go up, ARMs can get more expensive.
Fixed-Rate Mortgage
Fixed-rate mortgages offer stable, predictable monthly payments over the life of the loan. This can be reassuring for borrowers seeking consistency. But ARMs offer lower starting payments and the potential for savings if rates decline.
Making Your Decision
If you're sure you can handle adjustments or plan to sell or refinance, an ARM can be a smart choice. On the other hand, if long-term stability is a priority, a fixed-rate loan probably is better suited to your needs.
How Does An Adjustable-Rate Loan Work?
ARMs are long-term home loans with two periods: a fixed-rate period and an adjustable-rate period.
Fixed-Rate Period
During the starting fixed-rate period, your interest rate won't change. This period is typically the first 5, 7 or 10 years of the loan
Adjustable-Rate Period
This period comes right after the fixed-rate period. Your interest rate can go up or down during this period. The adjustments are based on changes with the benchmark index tied to the ARM (more on benchmark indexes soon). ARM mortgages usually have a 30-year terms, so during the adjustable-rate period, your rate is always changing.
Example:
An example would be if you take out an ARM with a 5-year fixed period. The interest rate would be fixed for the first 5 years of the loan. After that, your rate would adjust up or down for the remaining 25 years of the loan.
How are ARM Interest Rates Determined?
Various factors influence ARM interest rates. They include personal factors, like your creditworthiness, which affects the margin the lender sets upfront. There are also economic factors, like the current benchmark rate tied to your loan and its rate caps.
To calculate your mortgage rate, a lender adds the current benchmark rate to your margin.
Margins
The margin is a fixed percentage a lender adds to the current benchmark rate to decide your ARMs interest rate. Several factors decide your margin, including your credit score and credit history. With good credit, it is possible you'll qualify for a lower margin. Riskier loans can have a higher margin to account for the possibility of a borrower defaulting.
Benchmark Rates
The benchmark index specified in an adjustable-rate mortgage agreement is a key factor in determining an ARM's rate. It is also the basis for future interest rate adjustments.
For example, your ARM can be tied to a benchmark rate like the U.S. Treasury or the Secured Overnight Financing Rate (SOFR). Both are typically among the lower and more stable benchmark rates.
Rate Caps
Fortunately for borrowers, ARMs often feature a critical safeguard: interest rate caps. A rate cap limits how much your interest rate can increase during each adjustment period. These caps tied to your loans starting rate. This protects you from dramatic increases and makes adjustments more manageable for home owners.
When you shop for an ARM, you will see a set of three numbers listed by a lender. An example is 2/2/5. This series of numbers represent the details of your rate caps. Each number applies to a different phase of your ARM loan.
The first adjustment cap:
The first "2" is the cap on your interest rate during the first adjustment period. In other words, the new rate can't increase by more than 2% after the introductory fixed-rate period ends.
The next adjustment cap:
The second "2" is the cap on future rate adjustments. Generally, 2% is the standard adjustment cap.
The lifetime adjustment cap:
The "5" specifies how much the rate can increase in total over the loan. In other words, the ARM's interest rate can never exceed 5% more than your starting rate.
Important: Most ARMs offer a 5% lifetime adjustment cap. Some lenders, though, can have higher lifetime caps, resulting in an even more expensive loan. If you're considering an ARM, make sure you understand your lender's rate caps. The higher the caps, the higher the monthly mortgage payments will be if interest rates go higher.
Different Types Of ARMs
ARMs offer several loan structures to choose from. Here's a closer look at some of your choices:
5/1 And 5/6
Both 5/1 and 5/6 ARM offers a fixed-interest rate for the first 5 years of the loan term. The second number is the frequency of future rate adjustments after the first 5 years. With a 5/1 ARM, the rate adjusts once a year for the remaining loan term. With a 5/6 ARM, the rate adjusts every 6 months.
7/1 And 7/6
7/1 and 7/6 ARMs offer a fixed rate for 7 years. With a 30-year loan term, the starting fixed-rate period would last 7 years. Once the introductory period expires, you would make different payments. Those payments would be based on changing interest rates for the remaining 23 years on the loan.
Remember: Remember, interest rates rise and fall. You should make sure you can cover a higher mortgage payment down the road if you go with an ARM.
10/1 And 10/6
10/1 and 10/6 ARMs have fixed rates for the first 10 years of the loan. After year 10, the interest rate will periodically fluctuate based on market conditions. A 30-year loan term means 20 years of changing payments.
Conforming vs Non-Conforming ARMs
If you are considering an ARM, you'll also need to decide between going with a conforming ARM and non-conforming ARM.
Conforming ARMs
Conforming loans are mortgages that meet specific criteria that allow them to sell on the secondary mortgage market. Lenders sell their conforming loans. These mortgages meet the loan guidelines of Fannie Mae, Freddie Mac and the Federal Housing Finance Agency (FHFA). Fannie and Freddie then resell them to investors.
Non-Conforming ARMs
Loans that don't meet these specific guidelines are called non-conforming.
Non-Conforming ARMs
There are many reasons some borrowers choose a non-conforming loan. An example is a borrower needing a jumbo loan. They want to buy a home in a high-cost area and the loan they need exceeds the FHFA's loan limits.
Important: Just remember: if you're considering a non-conforming ARM, make sure you read the fine print on rate adjustments and caps. Your payments can get very expensive very quickly if the ARM has high caps.
Conventional vs Government-Backed ARMs
A conventional loan A conventional loan isn't backed by a government agency. Loans that are include: Department of Veterans Affairs (VA loans), Federal Housing Administration (FHA loans) or the U.S. Department of Agriculture (USDA loans).
If you use a government backed loan, like an FHA ARM or a VA ARM, your mortgage is non-conforming. That is because they don't follow Fannie Mae and Freddie Mac's rules. Some home buyers gain more from a government-insured mortgage. That is because the loans have different qualifying criteria and benefits (VA loan, for example).
Refinancing Out of an ARM
An ARM can be the right fit for some situations, but what if your financial circumstances change? You can refinance your ARM into a fixed rate mortgage to lock in more stability than an ARM can offer.
Thankfully, the process is very straightforward. When you refinance, you take out a new loan to pay off the original mortgage. Once the original mortgage is paid off, you start paying off the new mortgage.
Since a new mortgage is involved, you'll need to re-apply. You will go through many of the steps you took when you applied for your original loan. For example, your lender will ask for proof of income, like pay stubs and bank statements. They will also ask for details on your debts.
Speak with a lender, like SRK CAPITAL, to find out where interest rates are at. They can help you if you're considering refinancing out of your current ARM. If rates are higher than your current ARM, it is possible it isn't time to make the switch. But there are other loan choices that are available if your concerned about your ARM payments are not manageable.
Advantages of an Adjustable Rate Mortgage
ARMs can be the right move for borrowers who want to enjoy the low rates offered during the starting periods. With a lower upfront mortgage payment, you can:
- +Pay down your principal faster:
Take advantage of your low introductory monthly payments. You can do so by putting the extra money you save toward your principal loan balance each month. That way you pay off your loan faster.
- +Buy a starter home:
Many buyers pick a starter home to enjoy the lower monthly mortgage payments ARMs offer. The risks of an ARM are relatively minimal if you can sell the starter home before the rate starts adjusting.
- +Save and invest:
The money you save from your lower monthly ARM payments can help you build your savings. You can then use your savings to safeguard your finances if your interest rate spikes after the starting period.
They can be the best choice if you're moving somewhere you don't plan on living for more than 5 years. Also if you are looking for the lowest interest rate.
Disadvantages Of An Adjustable Rate Mortgage
Like any mortgage type, an ARM has some potential downsides.
- −Rates can go up:
The biggest risk of an adjustable-rate mortgage is the odds of your interest rate increasing. If your rate goes up, your monthly mortgage payments will go up, too.
- −Less predictable payments:
It can be difficult to budget long term when your interest rate and monthly payments fluctuate. If your rate rises, you can struggle to make the higher monthly payments. The possibility of future rate adjustments can be a concern for some home buyers.
Who Should Consider An ARM?
Typically, borrowers who prefer certainty, will opt to go with a fixed-rate mortgage. But an ARM can make more sense for those home buyers who move a lot.
If you're not buying a forever home, buying a house with an ARM makes sense. As long as you sell the home before the fixed-rate period ends, the lower starting rate means lower monthly payments.
Short-Term Home Owners
If you plan to move or refinance before the fixed period ends. An ARM can offer lower upfront costs and potential savings.
Risk-Tolerant Borrowers
If you are comfortable with some uncertainty. Or if believe rates will not climb significantly (or even fall), you can gain from the ARM's flexibility.
Risk Consideration
There's always the risk that you won't sell the house before your rate adjusts. If you can't sell, you can always consider refinancing into a fixed-rate or new adjustable-rate mortgage.
Refinancing Timing is Critical
Just remember, when it comes to refinancing, timing is critical. You will want to plan ahead and refinance before your rate is about to adjust. The interest rate on your original ARM can increase before your refinance is completed. That is why it is smart to get started at least a month before the fixed-rate period ends.
SRK CAPITAL can help you finish an ARM refinance in as short at two weeks if needed. Get in touch with our team today if you need help getting an ARM refinance done in a short timeframe.
Commonly Asked Questions
Get answers to frequently asked questions about adjustable-rate mortgages.
The Bottom Line
We know that you have many decisions to make when buying a home or refinancing. This includes whether to go with an ARM or fixed-rate mortgage.
Keep your finances, financial goals and future plans in mind whenever considering ARMs or any type of mortgage.
Our team at SRK CAPITAL can help you evaluate your choices so you can get the best mortgage for you.
If you think an ARM is the right for you, contact SRK CAPITAL today. Our great adjustable-rate mortgage choices come with competitive rates at great prices.
Ready to Explore Your ARM Options?
The mortgage experts at SRK CAPITAL are here to help you determine if an adjustable-rate mortgage is the right choice for your financial situation.