What is an ARM mortgage?

Posted on October 14, 2022 in Mortgage FAQ's

Buying a new home is an exciting process, but it can also be stressful, and when interest rates start to rise many people start asking, what is an ARM mortgage. Because very few people can purchase a home upfront in cash, most homebuyers take out a loan and pay a monthly mortgage. There are many different options available for financing a home, and one is the adjustable-rate mortgage. What exactly is an ARM mortgage, and is it right for you?

Keep reading to learn everything you need to know!

Adjustable-Rate Mortgage (ARM) Basics

What is an adjustable-rate mortgage? It is a mortgage with a variable interest rate. The initial interest rate is fixed for the home loan for a specified period of time. After that period, then the interest rate periodically resets. It can reset monthly or yearly.

The interest rate for ARMs changes based on a certain index or benchmark. Commonly, they use the London Interbank Offered Rate to determine the interest rate for a given period.

However, the good news is that ARMs have limits for the maximum amount the interest rate or total payment can increase per year or over the lifetime of the loan.

ARM vs Fixed-Rate Mortgage

Upon taking out a mortgage to purchase a home, you need to outline how you will pay it back. This includes determining the term length (commonly 15 or 30 years). Of course, to make it worth their while, the lender will also charge interest.

You can often choose between a fixed-rate mortgage or an ARM. For a fixed-rate mortgage, the interest rate is set for the life of the loan. On the other hand, the interest rates of an ARM vary after the initial period.

The initial borrowing costs of a fixed-rate mortgage are higher than those of an ARM. However, after the initial time period, then the interest impacting your monthly payment can go up or down. It all depends on the current state of the economy.

Therefore, ARMs may be more attractive at first. They are more affordable in the short term, but after that they carry some risk. Fixed-rate loans offer a greater sense of assurance, because you know exactly what your loan payments will be each month.

What if interest rates decrease? If you had a fixed-rate mortgage at a higher rate, then you may be able to refinance and pay off the loan with a newer one at a lower interest rate.

How Do They Determine the Variable Rate?

After the initial fixed-rate period, the ARM interest rates are adjustable. Therefore, they will fluctuate based on the index.

The ARM index is based on the benchmark rate of the Secured Overnight Financing Rate (SOFR), primate rate, the LIBOR, or the short-term rate in the U.S. Treasures. The benchmarks reflect the current state of the economy. The rate is set at a margin above the benchmark used.

How is the margin determined? It’s based on your credit history and a standard margin. There is a standard margin that accounts for the risk of mortgages compared by other loans indexed by benchmarks. The better your credit is, the closer to the standard margin you will pay.  

The index rate varies, but the margin stays the same. If the margin is 2.5% and the index is 4%, then the interest rate for the mortgage adjusts to 6.5%. If the index drops to 2%, the margin is still 2.5%, so the interest rate falls to 4.5%.

What if the benchmarks rise a lot? How much can you pay? What if the interest rate is unimaginable? Most ARMs have rate caps, which is a maximum interest rate adjustment during a set period in an ARM. This helps ensure more reasonable changes. Be sure to understand any caps in your mortgage before moving forward.

Types of Adjustable-Rate Mortgages

There are a few different types of ARMs to consider. Some common options include:

Hybrid ARMs

Hybrid ARMs begin with a fixed-rate period of anywhere from three to 10 years. After that, they have an adjustable period where the rate may change according to an index.

Most hybrid ARMs use the Secured Overnight Financing Rate (SOFR) to adjust rates every 6 months.

With these mortgages, the initial interest rate tends to be lower than fixed rate mortgages. The shorter the introductory period, the lower the rate tends to be.

These are written in a format where the first number dictates the time of the fixed rate and the second number the duration of the remaining loan. For example, 5/25 ARM means a fixed rate of 5 years followed by a floating rate for 25 years. A 5/1 ARM would have a 5-year fixed rate and then adjust every year after that.

Interest-only (I-O) ARM

Interest-only ARMs require you to only pay interest on the mortgage for a set time (3-10 years). After that time, then you begin to pay on the principal and interest of the loan.

This option could be helpful for those who really want to spend less on the first few years of their mortgage, to ensure they have funds for something else. However, opting for a longer I-O period means your payments will be higher after it ends.

Payment-option ARM

Payment-option ARMs have multiple payment options. The common options include:

  • Pay for the principal and interest
  • Pay down only the interest
  • Pay a minimum amount that does not cover interest

While it may be tempting to pay the minimum amount or only the interest, you will eventually have to pay the lender back everything by the specified date. The longer you take to pay off the principal, the higher the interest charges are. The longer you pay off only the minimum, the more the debts grow.

When an ARM is Beneficial

Is an ARM right for you? For some homebuyers under certain circumstances, an ARM may be the wise financial choice.

The following art times when an ARM is beneficial:

It’s Not Your Forever Home

If you know the home you are buying is one you plan to leave in a few years, then an ARM may be more cost-effective. For example, if you plan to move out of state or buy a home to meet your current (and not future) needs, then consider an ARM. You would get a low introductory fixed rate, and then could sell the home before the interest rates were adjusted.

Quickly Pay Off Mortgage

While most mortgages are for 15 or 30 years, you can certainly pay it off quicker. If you plan to pay yours off faster, then you could save money. If you know you are getting an inheritance, bonus, or other financial windfall, then you could again save money with the low introductory rate. This is best if you know you receive the necessary money before the end of the fixed-rate period.

Low Initial Payments are Priority

After the initial fixed rate, the direction of adjustable-rate mortgages is not predictable. The benchmark could drop, lowering interest rates. However, it would likely increase and cause interest rates to climb. There’s no way to predict this with certainty.

However, if low initial rates are your priority and you are okay with the risk of higher payments later on, then an ARM may be a good fit. Another key benefit of the lower rate is that you can pay more toward the principal upfront, helping you to reduce your loan balance by more if you choose.

When an ARM Is Not the Best Idea

While ARMs may have their place for some homebuyers, they are not always the best option. The initial low rates are enticing, and they can make it possible for you to get a bigger loan for a home. However, fluctuating payments are tough for budgeting. The payments can change drastically, which could put you in financial trouble.

If you do plan to stay in the home for the long term, then it’s more cost-effective to stick with a fixed-rate mortgage. Additionally, if having a constant mortgage payment is better for you financially, then strongly consider the fixed-rate mortgage.

Determine if an Adjustable-Rate Mortgage is For You

An adjustable rate mortgage may be suitable for those who plan to sell a home or pay off their mortgage completely by the time the adjustable rate kicks in. The initial low interest rate is highly attractive and may allow you to keep cash flow for another purpose.

That being said, the risk of adjustable rate mortgages is that you don’t know how the interest rates will change. The benchmarks reflect the economy, which can vary greatly. This means you may be in store for higher payments, and won’t have a consistent mortgage payment to count on.

Based on the information above regarding ARMs, you must assess your financial situation and determine whether an ARM or fixed-rate mortgage is best for you.

But you also need to find the right home! We’re here to help you find the Triangle home to suit your needs. Check out our available properties online. Contact us for help finding your home today!

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