Unlike a fixed-rate mortgage where the interest rate remains the same for the life of the loan, an adjustable-rate mortgage (ARM) has an interest rate that can increase or decrease several times during the mortgage term. ARM’s are riskier for the borrower, especially if interest rates take a significant uptick, but they are the right in many instances. Learn more about adjustable-rate mortgages and compare them to conventional fixed-rate mortgages before you start shopping for your dream home so that you go into the process with everything you need to know.
How does an adjustable-rate mortgage work?
ARM’s start out very much like their fixed-rate counterparts with stable interest rates and payments that do not change. This fixed-rate period of the loan can be as short as one month or as long as 10 years, depending on the lender and your financial situation. Once the fixed-rate period ends, the loan’s interest rate is subject to change and may increase or decrease depending on the prevailing rates. Most ARM’s can only change once per year, and there’s usually a cap on how much they can increase (or decrease) at one time and cumulatively over the life of the loan.
What are the advantages of an adjustable-rate mortgage?
One of the biggest draws that make adjustable-rate mortgages appealing to home buyers is that the interest rates at the start of the loan are typically lower than those of conventional fixed-rate mortgages, which results in lower monthly payments. Lenders also tend to loosen up on their financial criteria, so the amount of a down payment and your overall credit score can be slightly lower. For many buyers, ARM’s make home ownership more feasible and affordable.
What are the downsides to adjustable-rate mortgages?
While it’s possible that your interest rate may decrease at the end of the fixed-rate period, it’s also possible that it can increase, which will make your monthly payments larger. Adjustable-rate mortgages also tend to be more complicated and difficult to understand than simple fixed-rate mortgages, so there’s a much steeper learning curve. And unless your psychic, you have no idea what your future mortgage payments will be when you take out the loan.
How is the interest rate determined on an adjustable-rate mortgage?
Conventional fixed-rate mortgages are tied to the federal interest rate, but ARM’s are tied to one of three major indexes, and your loan documents will disclose which one your loan is tied to.
- The one-year Treasury bill
- The 11th District cost of funds index (COFI)
- The London Interbank Offered Rate (LIBOR)
Your loan documents will also state a margin, and that’s added to the index’s rate to get your new interest rate. If your index is 2 percent and you have a margin of three percentage points, then your interest rate will be 5 percent. If the index changes the following year to 1.5 percent, then your new interest rate will be 4.5 percent.
How often can the lender change my interest rate?
While your initial fixed-rate period may last anywhere from one month to 10 years, the most common terms are three, five, seven or 10 years. Most lenders only review and possibly change your interest rate once per year. If your ARM has a three-year fixed-rate period and the rate can only change once per year, it would be known as a 3/1 ARM. A loan with a five-year fixed-rate period and interest rate review every two years would be a 5/2 ARM.
Are there limits on how much my interest rate can change?
Every adjustable-rate mortgage has three caps: an initial adjustment cap, a periodic adjustment cap and a lifetime cap. The initial adjustment cap, which is often the same as the periodic adjustment cap, puts a limit on how much your interest rate can increase or decrease after the fixed-rate period on the loan ends. The periodic adjustment cap limits how much your rate can change at each review, and the lifetime cap puts a limit on how much your rate can cumulatively increase over the life of the loan. Generally, 3/1 ARM’s are capped at 2/2/6. This means that the interest rate can’t increase more than two percent after the fixed-rate period ends and at each periodic review. There’s also a 6 percent limit on how much the rate can increase over the life of the loan.
If you take out a 3/1 ARM with a three percent interest rate and caps of 2/2/6, it’s possible that your interest rate may increase to five percent when the fixed-rate period ends. In year four, it’s possible that it will increase another two percent, leaving you with an interest rate of seven percent. However, because the loan has a six percent lifetime cap, your interest rate will never exceed nine percent.
Let’s look at this in dollars and cents. If you take out a 3/1 ARM for $200,000 with a three percent interest rate over 30 years and caps of 2/2/6, your monthly payments would be $843.21. If the rate increases by two percent after the fixed-rate period ends, your payments could increase to more than $1,000 per month. Another two percent increase in year four would bring your payments up to more than $1,300, and one last two percent increase at any point during the loan would take your payments to their maximum of more than $1,600.
While an adjustable-rate mortgage might be the best choice for your financial situation, make sure you read all of the fine print before you sign. If you don’t understand everything you’re getting into, you could find yourself in financial difficulty down the road.
