Denice R. Preston
A mortgage can be used to buy a property, such as a primary or secondary home, rental condo, apartment, condo, or rental. This agreement is between you and a bank, credit union, or another lender specifying the payment terms. If you do not make your payments on time, the lender can return the property. The property is used as collateral for the loan.
Fixed rate mortgages are the most popular type. Fixed rate mortgages lock you in to a fixed interest rate for the term of the loan, usually 30 years.
Fixed rate mortgages offer stability, but they are not the only option. You may choose to finance your home purchase using an adjustable-rate mortgage (ARM), depending on your financial situation and your willingness to take risk.
How an Adjustable Rate Mortgage differs from other Mortgages
Variable interest rates are the most distinctive characteristic of adjustable-rate mortgages. They are often tied to market conditions. The rate is fixed for the first few years, much like a fixed-rate mortgage.
After the fixed period expires, however, your interest rate starts to adjust regularly. Sometimes, it can be as often as every six months. These adjustments can have a positive or negative effect on your monthly payment depending on the market. However, you should expect rates to rise substantially. An ARM is more risky than a fixed rate mortgage if you don’t intend to sell or refinance your home before the terms change.
What you need to know about ARM Terms
The initial fixed period of an ARM is usually 3, 5, 7 or 10 years. An ARM’s initial fixed period is usually 3, 5, or 7 years. Sometimes, even 10, it can be as short as 10 years. This means that you will often get a lower interest rate than a fixed-rate mortgage. Bankrate shows that the average annual percentage (APR), for a 30-year fixed rate, is up to 6.2% (as of September 16, 2022), while the average APR for a 5-year adjustable rate mortgage (ARM) is 4.67%.
Fixed-rate mortgages can be more complex than ARMs because of the frequency that your interest rate and payment changes. There are many things you need to know about the terms.
Adjustment frequency : The time between interest rate adjustments.
Adjustment Indexes: Your ARM’s interest rate will change based on the interest rate of a type asset such as a certificate or deposit. Or a benchmark rate such as the Secured Overnight Finance Rate (SOFR).
Margin is the difference between your rate or the adjustment index. The margin on your loan is a percentage that you pay over the adjusted index. This could be 2% or more.
Caps – A cap is a limit on how much the interest rate may rise during an adjustment period.
Ceiling : The maximum adjustable interest rate that can be set during the loan’s life.
Lower interest rate. An ARM has the greatest benefit: it usually comes with a lower interest (APR) as well as a more affordable monthly payment for the first few year.
Lower loan limit. You may be eligible for a larger loan through an ARM because of the lower APR.
The drawbacks of an adjustable-rate mortgage
ARMs can have serious downsides, especially if you intend to purchase the property after the fixed-rate period ends. The Consumer Financial Protection Bureau suggests these things:
Even if interest rates are not rising, your monthly payments may go up.
You may not see any decrease in your payments, even if interest rates drop.
Even if all your payments are on time, you might end up with more debt than you borrowed.
You might have to pay a penalty if you pay your ARM off early in order to avoid higher monthly payments.
A negatively amortizing loan is another thing to be aware of. This type of ARM offers a low monthly payment that might not cover all your monthly interest. Unpaid interest is then transferred to your principal balance, which in turn increases your loan balance. This could mean that your principal balance may be higher than the amount you borrowed after years of making payments.
What are the best times to use an adjustable-rate mortgage?
These types of borrowers are the best candidates for ARMS:
A person expecting an income increase
If you are nearing the end of your medical residency, and expect to see a substantial income increase, an ARM might be a good option with a guaranteed pay rise.
You don’t intend to keep the home or the loan for very long
Do you expect to move within the next few years? Are you planning to purchase a new house or refinance your current home? This might be a good option if you don’t plan on keeping the ARM beyond the point at which the APR increases. Be aware of early payment penalties.
It is important to remember that an ARM can be costly if you are unable to afford a home. A fixed-rate mortgage is the best way to buy a home.
How to apply for an ARM
The process for applying for an ARM is similar to applying for a fixed rate mortgage. To determine the loan products that you are eligible for, you will need to meet with a lender (or loan broker if you are looking for rates). The following documentation will be required:
Employment and income proof
Recent W-2s (if applicable, 1099s)
Information about bank accounts
Based on your credit history and available assets, the lender will decide how much they can lend you.
An ARM is a risky type of loan if you don’t have the plan to cover the adjustable-rate years (such as the sale of your property). You need to plan what will happen if the rate increases, especially if you are relying on the lower monthly payment and APR for the first 3-7 year.
