An adjustable-rate mortgage is a home loan that helps home buyers purchase a home with a lower interest rate. It is the best choice for refinancing and first-time buyers. If interest rates remain low, you can afford your ARM payments for the duration of the loan’s introductory period.
Additionally, the initial rate of an ARM can vary, ranging from five years to seven or ten years. As of May 2024, the average initial rate for a popular ARM, the 5/1 ARM, is 5.96%. It is lower than the fixed-rate mortgage, i.e., 6.6%–7.2%.
Moreover, with this mortgage, the interest rate is fixed for a while and then changes periodically as per market conditions. So, get pre-approved for a low ARM rate today.
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What Is an Adjustable Rate Mortgage?
Adjustable-rate mortgages are more affordable for homebuyers as compared to fixed-rate mortgages. This type of mortgage is also known as a floating mortgage. In this loan, the rate is fixed for a short period of around 5 years and then changed.
Whereas, in fixed-term mortgages, the interest rate is the same over the life of the loan term. Aside from that, the interest rates on ARMs fluctuate according to the market rate plus an additional amount that the lender sets.
How does an Adjustable Rate Mortgage Work?
ARM mortgages work in two ways, integrated into one loan agreement. It starts with a fixed-rate term between 5 and 10 years. After that, it converts to a variable rate loan with an ARM mortgage interest that changes every 6 months or annually. It is entirely dependent on what term you choose.
- Fixed Period: ARMs start with a super low rate, saving you money early on. Usually, this introductory phase lasts three, five, or seven years. During this time, you pay monthly payments that are lower than what you’d get with a fixed-rate mortgage.
- Adjustable Period: The adjustable period in ARM begins after the fixed period ends. It allows until you sell, refinance, or pay off the loan.
- Rate of Adjustment: An ARM loan tells you how often it adjusts after the fixed rate period (e.g., “5/1” adjusts annually, “7/6” adjusts every six months).
To estimate how these rate changes could impact your monthly payments, use a mortgage calculator to compare different scenarios
Adjustable vs. Fixed Rate Mortgages
Choosing an adjustable-rate mortgage is always beneficial for home buyers as it lowers upfront costs and potential savings. Whereas, in a fixed-rate mortgage, there is a stable payment for the long term.
| Feature | Adjustable Rate Mortgage | Fixed Rate Mortgage |
| Monthly Payment | Lower in the first years and could rise after adjustments. | Consistent and established throughout the loan term. |
| Interest Rate | It starts lower than the fixed rate and adjusts frequently after the intro period. | Remains constant throughout the loan. |
| Risk | Interest rates rising could result in higher monthly payments. | There is no chance of receiving an unexpected payment rise. |
| Qualification | More easily qualified for with a lower DTI requirement. | Needs a better financial profile and a higher credit score. |
What are ARM Rate Caps?
Adjustable-rate mortgages come with ARM rate caps. It sets a limit on how much interest rates can change over time. There are 3 types of rate caps:
- Initial Rate Cap: This rate cap limits the amount and the interest rate. It can increase or decrease. If the initial rate cap is 3% and the initial interest rate is 4%. The maximum interest rate in the first adjustment period would be 7%.
- Lifetime Rate Cap: It sets the maximum interest rate that can be charged over the complete loan period. If the lifetime rate cap is set at 5%, the interest rate can never go above 5% for the term of the loan.
- Periodic Rate Cap: This periodic rate cap limits the amount and the interest rate can increase or decrease. It fluctuates during each adjustment period. If the rate cap is set at 2% and the current interest rate is 4%. The maximum interest rate in the upcoming adjustment period would be 5%.
Types of ARMs
There are 3 types of ARMs such as hybrid ARM, interest-only ARM, and payment option ARM.
- Hybrid ARM: A hybrid ARM is a traditional adjustable rate mortgage that starts with a fixed interest rate. It usually lasts for 3 to 10 years and then the rate adjusts up or down as per the preset schedule.
- Interest-Only ARM: An interest-only ARM is an adjustable rate mortgage where you only pay the interest for a certain period of time. Once this interest period ends, you need to start making full principal and interest payments.
- Payment Option ARM: In payment option ARM, you can schedule your payment structure and schedule. It could be for a 15 -30 or 40-year term, or any other payment equal to or greater than the minimum payment.
Pros And Cons of an Adjustable Rate Mortgage
Adjustable rate mortgages come with various advantages and disadvantages. The following are:
| Pros | Cons |
| Low introductory rates in ARMs can mean smooth sailing with payments during the fixed period. | Unlike fixed-rate mortgages with stable payments throughout the loan, ARMs can cause fluctuations in your monthly payments. |
| The low-interest rate is the main benefit of an adjustable-rate mortgage. | The biggest concern is the unpredictability of ARM’s future interest rates. |
| ARMs usually have a lower debt-to-income ratio, as it can exceed more than 50%. | ARM terms can be more intricate than fixed-rate mortgages |
Bottom Line
If you’re a homeowner or buyer who wants to sell or purchase a home, choosing an adjustable-rate mortgage is beneficial. In addition to this, selecting the right lender is also important because they can assist you if ARM aligns with your specific budget and needs.
Moreover, lenders can also help you determine different scenarios based on fluctuations in interest rates on ARM. It can help you calculate accordingly to make monthly payments.
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Frequently Asked Questions
What are the benefits of an ARM?
The advantages of an ARM include reduced interest rates, cost savings, and flexibility for short-term ownership.
What are the risks of an ARM?
ARMs offer lower initial rates but come with the risk of significant payment increases if interest rates rise after the fixed period.
Is an ARM right for me?
Yes, an ARM is a good option if you’re purchasing a home for the first time. It is also helpful if you’re planning to sell your house within an introductory period before interest rates rise.
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