Adjustable Rate Mortgages (ARMs)
These loans generally begin with an interest rate that is 2-3 percent below a comparable fixed rate mortgage, and could allow you to buy a more expensive home.
However, the interest rate changes at specified intervals (for example, every year) depending on changing market conditions; if interest rates go up, your monthly mortgage payment will go up, too. However, if rates go down, your mortgage payment will drop also.
There are also mortgages that combine aspects of fixed and adjustable rate mortgages – starting at a low fixed rate for seven to ten years, for example, then adjusting to market conditions. Ask your mortgage professional about these and other special kinds of mortgages that fit your specific financial situation.
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What Are Adjustable Rate Mortgages?
Purchasing a home is one of the biggest decisions and largest purchases you will ever make. It is an exciting time filled with making lists of what you want your home to be like, what your must haves are, and touring homes that are for sale. On the other hand, buying a home can also be a stressful time. There are financial documents, credit checks, financing options, home inspections, different types of mortgages, and of course, massive amounts of paperwork. But, no matter how daunting all that can be owning your own home provides a sense of pride, security, and an investment in your future. The purchase may be large, but the benefits are even larger. Determining what type of mortgage is right for you is one of the first steps to buying a home. After all, paying on your home loan is probably going to be one of your largest monthly expenses, so you need to understand what mortgage will work for you.
Mortgage Types: Fixed Rate Mortgage and Adjustable Rate Mortgage
There are two main types of mortgages. Fixed rate mortgages are self-explanatory, the interest rate stays the same for the entirety of the loan. Adjustable rate mortgages, or ARMs, however are more complicated. The interest rate of an adjustable rate mortgage is usually fixed for a period and then begins to adjust, going either up or down, depending on the index rate that the loan is tied to. So, what does that mean? Well, most adjustable rate mortgages begin with a fixed interest rate which is usually lower than the interest rate tied to fixed rate mortgages. They will have this interest rate for a set number of years, three, five, seven or maybe even ten. Once the fixed time has passed the interest rate will change depending on an index and margin. How often the interest rate changes will also be determined by the loan.
How to Understand an Adjustable Rate Mortgage
Adjustable rate mortgages are usually expressed with two numbers. The first number is the number of years that the interest rate is fixed but the second number does not have a set designation. In the case of a 5/1 adjustable rate mortgage the five indicates that the interest rate is fixed for the first five years of the loan, after that it can be changed once per year. Fairly simple. But some loans may be a 3/27 which would have a three-year fixed rate and then have a floating rate for the other twenty-seven years of the loan. A 5/5 ARM would have a fixed rate of five years and could then be adjusted every five years after that. That formula does not always work though, a 5/6 adjustable mortgage rate would have a fixed interest rate for five years and then adjusted every six months. The discrepancy of the second number is why it is extremely important to understand what adjustable rate mortgage is right for you.
How the Index Rate and Margin Affect Adjustable Rate Mortgages
As mentioned, after the fixed time frame of an adjustable rate mortgage is up the interest rate can go up or down depending on the rate index and margin associated with the loan. So, what is the index and what is the margin? An index is determined by different market forces and is always from a neutral party. There are several different indexes so which one your loan follows will be specified in your loan papers. Just like the housing market can go up and down so can indexes so they are always changing. Margins on the other hand are fixed percentage points that do not change. The agreed upon margin will also be listed in the loan documentation. Together, the index and the margin determine the new interest rate. For example, if the margin of a loan is 3% and the index is 4% then they are added together, and the new interest rate will be 7%. If the index drops to 1.25% the next time the rate is evaluated, then the interest would drop to 4.25%.
How the Index Rate and Margin Affect Adjustable Rate Mortgages
Adjustable rate mortgages can be risky and are not right for everyone. However, there are also a lot of benefits if you are in the right situation. Here is a list of pros and cons when considering an adjustable rate mortgage. The pros:
- Low interest during the fixed phase—Typically the interest rate is very low during the years that it is fixed which means that your payments are also low.
- Flexible—If you plan on moving or paying off your loan within the fixed-rate phase an adjustable rate mortgage would be great for you. You would be able to benefit from the low fixed interest rate and sell or pay off the loan before the rate changed.
- Rate and payment caps—Normally there are caps associated with ARMs which include interest rate caps and caps on how much your monthly payment can grow when the rate adjusts. These caps can help protect you from massive increases.
- Smaller monthly payments—There is always the possibility that your payments could get smaller. If the index drops so will your payments.
- Larger monthly payments—Just like your payments going down they could go up. If the index is high when your rate is adjusted, then you would have a larger monthly payment.
- Things can change—Adjustable rate mortgages require a lot of planning, so you can adjust when the fixed phase is over. But sometimes things don’t go as planned which could leave you in a place where you could lose your home.
- Prepayment penalty—Some, but not all ARMs come with a prepayment penalty which is a fee that you will be charged if you sell or refinance the loan. You must find out from your lender if your loan has a prepayment penalty.
- Complex—The structure, rules and fees associated with adjustable rate mortgages are complex, so you must clearly understand your loan.
Finding an Adjustable Rate Mortgage Lender
There are lenders all over the country that provide the option of an ARM. What’s important is making sure you are matched with one that will give you the best interest rate. If you live in these areas:
- Queen Creek
- Sun City West
- Litchfield Park
- Paradise Valley
- Casa Blanca
- Chandler Heights
- Sun Lakes
- Cave Creek