Adjustable rate mortgages (ARMs) are a popular mortgage choice for home buyers. Compared to traditional fixed-rate loans, an ARM offers a lower introductory interest rate during the initial few years of the loan, helping you reduce monthly mortgage payments. Unfortunately, after this period ends and market conditions take their course, your rate may change according to market conditions.
Selecting an adjustable-rate mortgage can be complex, so it is essential to understand its terms and options. Your loan’s timing sequence for interest rates, any applicable caps, as well as any penalties that will arise if you fail to fulfill its conditions will all need to be taken into consideration.
How ARMs Work
The most popular adjustable-rate mortgage (ARM) is the 5/1 ARM, which features an introductory rate for five years that changes annually. Other ARMs offer introductory periods of three, seven or 10 years. After these initial months have elapsed, your interest rate will fluctuate based on an index; your lender will provide you with both when you receive your paperwork for the ARM.
Once the introductory rate expires, your interest rate will adjust annually based on an index value about 45 days before the anniversary date of your loan. This index typically uses either the Secured Overnight Financing Rate (SOFR) or yield on Treasury bills; however, some lenders use other benchmarks like certificates of deposit.
Indexes are determined by a third-party arbitrageur and lending analysts review the potential changes in an index over time. They then use computer simulation methods to decide if offering an ARM is profitable and tolerable for lenders, using objective criteria.
If the lender opts to offer an ARM, they must guarantee that it will be profitable during the initial adjustment period. Oftentimes, both parties will agree on a cap for how much the interest rate can increase each period or over the life of the loan.
A periodic rate cap restricts the amount that an interest rate can vary between adjustments, typically setting it at 1% above the Start Rate for loans with an initial fixed term of three or more years or 2% above for those with five or more years. Most ARMs also feature a lifetime cap of either 5% or 6% above their Start Rate.
Risks of An ARM
The primary concern with an ARM is that you could end up stuck in an unaffordable home due to increased interest rates. Depending on your individual financial situation, you may struggle to afford the mortgage payments if rates rise; alternatively, you could be forced to sell your house.
Before making a decision, take into account both your budget and objectives. Are you searching for an attractive introductory interest rate or hoping to pay off your mortgage faster? There are various loan types available such as conventional, FHA and VA loans.
What Is The Ideal Arm for You?