If you’re considering buying a home, you may be considering an Adjustable-rate mortgage (ARM) as one of your financing options. An ARM is a type of mortgage loan where the interest rate adjusts periodically based on a predetermined index. While ARMs can offer lower initial interest rates compared to fixed-rate mortgages, they can also be more complex and riskier for borrowers.
In this article, we’ll explain how Adjustable-rate mortgage works, their advantages and disadvantages, and how to decide if an ARM is the right choice for you.
How an Adjustable-Rate Mortgage Works
An adjustable rate mortgage is a loan where the interest rate can change periodically over the life of the loan. The rate is typically based on a predetermined index, such as the London Interbank Offered Rate (LIBOR) or the Constant Maturity Treasury (CMT) index, plus a margin added by the lender. The margin is a fixed percentage that is added to the index rate to determine the borrower’s interest rate.
ARMs typically have an initial fixed-rate period where the interest rate stays the same for a set number of years, usually between 5 and 10 years. After the fixed-rate period ends, the interest rate can adjust annually, quarterly, or monthly, depending on the loan terms. The adjustment is based on changes in the index rate, and the margin remains the same.
Advantages of an Adjustable-Rate Mortgage
The main advantage of an adjustable rate mortgage is the lower initial interest rate compared to a fixed-rate mortgage. This can help borrowers qualify for a higher loan amount or lower their monthly payments during the initial fixed-rate period. This can be especially beneficial for borrowers who plan to sell their home or refinance before the rate adjustment period begins.
Another advantage of ARMs is that they may be a good choice for borrowers who expect their income to increase in the future. If you expect to earn more money in the future, you may be able to afford higher mortgage payments when the rate adjusts. This can help you save money on interest charges over the life of the loan.
Disadvantages of an Adjustable-Rate Mortgage
One of the main disadvantages of adjustable-rate mortgage is that the interest rate can increase significantly after the fixed-rate period ends. This can lead to higher monthly payments, making it more difficult for some borrowers to afford their mortgage. Additionally, if interest rates rise sharply, borrowers may find themselves with an unaffordable mortgage payment.
Another disadvantage of ARMs is that they can be more complex and difficult to understand compared to fixed-rate mortgages. Borrowers need to understand how the rate adjustment works, including the index rate and the margin, and how changes in interest rates can affect their mortgage payments. This can make it more challenging for borrowers to compare different mortgage options and choose the best loan for their needs.
Is an Adjustable-Rate Mortgage Right for You?
Deciding whether an adjustable rate mortgage is the right choice for you depends on several factors, including your financial goals, risk tolerance, and future plans. If you’re comfortable with some level of risk and expect your income to increase in the future, an ARM may be a good option. However, if you prefer a more predictable monthly payment or expect to stay in your home for a long time, a fixed-rate mortgage may be a better choice.
It’s also essential to consider your ability to handle higher mortgage payments if interest rates rise. You should review the loan terms carefully, including the rate adjustment caps, to understand how much your payments can increase if rates rise.
An adjustable rate mortgage can be an attractive option for borrowers who want a lower initial interest rate and are comfortable with some level of risk. Call Abo Capital today to discuss your options with one of our experts at: 310.984.8028
- What is an adjustable-rate mortgage (ARM)? An adjustable-rate mortgage (ARM) is a type of home loan in which the interest rate can change over time. Unlike a fixed-rate mortgage, which has a set interest rate for the life of the loan, an ARM typically has an initial fixed-rate period followed by a period in which the interest rate can adjust periodically based on an index such as the LIBOR or Treasury rates.
- How do adjustable-rate mortgages work? During the initial fixed-rate period of an ARM, the interest rate is set and remains the same. After this period ends, the interest rate on the loan can adjust periodically based on the index chosen by the lender. The adjusted rate can be higher or lower than the initial rate depending on market conditions. The frequency of rate adjustments, as well as the maximum rate that the loan can reach, will be set in the loan agreement.
- What are the benefits of an adjustable-rate mortgage? One of the main benefits of an ARM is that the initial interest rate is typically lower than that of a fixed-rate mortgage. This can make homeownership more affordable for buyers who may not qualify for a fixed-rate loan or who are looking to keep their initial mortgage payments low. Additionally, if interest rates decline after the initial fixed-rate period, homeowners with ARMs can potentially enjoy lower monthly payments.
- What are the risks of an adjustable-rate mortgage? The main risk of an ARM is that the interest rate can increase after the initial fixed-rate period, which could lead to higher monthly mortgage payments. If the interest rate rises significantly, the borrower could also end up owing more on the loan than the home is worth, which is known as being “underwater.” Homeowners with ARMs should carefully consider their ability to afford potential increases in mortgage payments and have a plan in place for when rates do eventually rise.
- Who is a good candidate for an adjustable-rate mortgage? An ARM may be a good option for homebuyers who are planning to move or refinance before the initial fixed-rate period ends, as they can take advantage of the lower initial rate without worrying about future rate increases. Homebuyers who expect their income to increase over time may also benefit from an ARM, as they will have more flexibility to pay off the loan faster or refinance if needed. However, homeowners who plan to stay in their home long-term and prefer the stability of a fixed-rate mortgage may want to consider that option instead.