Should you consider an ARM for your next mortgage?
If you’re a potential homebuyer, rising interest rates and home prices might have you considering all options for funding. But there’s a mortgage option, called an ARM (Adjustable Rate Mortgage), you might not be familiar with — one that could help get you into the home of your dreams and potentially save you some money.
ARMs offer an alternative to traditional fixed-rate mortgages. Here’s a brief explanation of how ARMs work and how to decide if and when they might be the right home financing solution for you.
What is an ARM and how does it work?
Unlike a fixed-rate mortgage where the interest rate stays the same for the life of the loan, an ARM starts with a fixed interest rate for a certain period, typically 5, 7 or 10 years. But once that period ends, the interest rate may change at set intervals for the remainder of the loan.
For example, a 5/1 ARM has a fixed interest rate for the first five years, followed by a variable rate period where the interest rate could adjust every year until the loan is paid off. That means the interest rate could go up, down or remain the same, depending on market conditions and the terms of the loan.
When does an ARM make sense versus a fixed-rate mortgage?
“The number one benefit is that eligible borrowers can likely obtain a lower initial interest rate on an ARM than what they could on a fixed rate-mortgage,” explains Todd Farley, Senior Vice President, Mortgage Sales and Production Manager, Commerce Bank.
"A mortgage loan with a lower interest rate would mean a lower initial monthly payment."
Another benefit is that this type of mortgage may offer the flexibility for modifications. “Let's say you’ve had a seven-year ARM for three years and interest rates change dramatically,” says Farley. “You might choose the option to either modify your loan into another ARM or into a fixed-rate mortgage.”Modifications typically have lower fees compared to closing on a new loan and the process can usually be completed in about a week.
Adjustable interest rates might make this option seem riskier than a fixed-rate mortgage. Yet, the lower initial rate could make it easier to get into the home you want now. With an initial lower interest rate and lower monthly payment, you may be able to pay down your principal and build equity faster.
Your principal is the amount of money that you borrow. Home equity is the market value of a homeowner’s interest in their real estate property. It’s calculated by determining the current fair market value of the home, minus the amount you owe toward its mortgage payment or other loans secured by the home.
You might choose this type of mortgage if you don’t plan to stay in your home beyond the fixed-rate period. “Many people have a plan to live in a home for a certain period of time,” says Farley.
"For example, if you’re in the military, anticipate a relocation or growing out of a starter home after a few years, you may not need a 30-year fixed-rate mortgage. An ARM might make better financial sense in those situations."
Other facts and considerations.
The biggest factor to keep in mind with an ARM is that the interest rate will likely adjust after the initial period of 5, 7 or 10 years, and changing interest rates will impact your payments. If interest rates go down, they can become less expensive than fixed-rate mortgages; but they can also become relatively more expensive if rates go up. “The new rate is based on two numbers known as the index and the margin, and these should be made clear in the borrower’s loan documents,” says Farley, who adds that borrowers are notified at least 90 days in advance of their rate changing.
The index reflects market conditions. The margin is the number of percentage points added to the index by your lender. The margin is set in your loan agreement and won’t change after closing.
Your loan details should also clearly indicate periodic rate caps that limit how much your interest rate can change from one adjustment period to the next, as well as a lifetime rate cap, that sets limits on how much the interest rate can change in total over the life of your loan. These rate caps are in place to protect borrowers with an ARM in the event of a significant interest rate increase.
Here are a few other factors to help you decide if an ARM might be the right financing option:
You may need to qualify for the initial interest rate plus two percentage points to ensure you’re able to afford the monthly payment if the interest rate climbs to the maximum of 2% over the starting interest rate
Ask questions and be sure you clearly understand the loan terms, especially the initial rate term, the frequency of rate changes, and your rate caps
- Be aware that if your interest rate changes, so will your monthly mortgage payment — so make sure you have room in your budget for potentially higher future payments
During periods of high interest rates, an ARM could be a smart mortgage option to help you save money with an initially lower rate and payment. In any type of interest rate environment, it’s always a good idea to consider all available mortgage options as well as your financial picture and goals before choosing a home loan.
“I would encourage borrowers to talk to a professional to help them understand their options before deciding between an ARM and a fixed-rate mortgage,” adds Farley.
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