Homeownership marks the beginning of a new chapter in most people’s lives; however, getting a mortgage requires careful consideration of your financial situation and goals. There are significant differences between an adjustable-rate mortgage and a fixed-rate mortgage, with the former often tempting borrowers with cheaper interest rates. But is it the better choice for you?
Adjustable-Rate Mortgage Definition
Adjustable-rate mortgages (ARMs) are mortgage loans with interest rates that can fluctuate and change based on market conditions. If you’re looking for the lowest possible mortgage rate from the start, an ARM is usually the better choice than a fixed-rate mortgage, which usually has higher interest rates that remain the same for the entire duration of the loan.
While an ARM might be advantageous at first, the fact that your monthly payments will shift over time can make it more challenging to budget.
How Does an Adjustable-Rate Mortgage Work?
Knowing how an adjustable-rate mortgage works can help you plan ahead based on your financial goals and prepare for fluctuating payments and interest rate changes.
The variable payments of an ARM are determined by the conditions of your specific loan and a benchmark rate index – and they are available in two periods:
- Initial period: The initial period or fixed-rate period is when the interest rate of the loan doesn’t change. Common ARM terms are 5, 7, or 10 years.
- Adjustment period: The adjustment period determines when and how often the interest rate can change. Your interest rate can rise or fall during this time period based on the terms of your loan and in response to changes in the benchmark rate.
Example: If you get a 30-year ARM with a 5-year fixed term, your interest rate won’t vary for the first 5 years but will start to fluctuate for the remaining 25 years. ARMs also have a rate cap structure, which limits how much the interest rate can change.
While ARMs can be unpredictable, they can be an excellent solution for certain types of borrowers. Homeowners who plan to live in their home for a relatively short time (as opposed to the entire term of the loan) can potentially benefit from this type of mortgage.
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Pros and Cons of an Adjustable-Rate Mortgage
An adjustable-rate mortgage may be a fine choice for some homeowners, but whether it’s a viable option depends on your financial goals and needs.
Advantages of an Adjustable-Rate Mortgage
- The lowest rate possible – Many lenders offer introductory rates for set periods, resulting in lower monthly payments.
- Savings – With an ARM, you can potentially save money on your mortgage payments and use that money toward a down payment on your next home if you plan on selling the property before the adjustment period starts.
- Flexibility – When buying a property as a stopgap until you can find a bigger one, an ARM may be the ideal choice if you sell before the ARM’s adjustment period starts.
- Rate and payment caps – While the rate changes, adjustable-rate mortgages have caps on how much the rate can rise each time it increases over the loan’s lifetime.
- Decreased payments – While many only consider the disadvantages of the loan’s adjustment and associate it with larger payments, an ARM can also significantly reduce your payments.
- Convert – If you have a convertible ARM and don’t plan on selling, you may refinance it into a fixed-rate loan after its introductory fixed-rate term is complete. However, if you meet the requirements, you may convert any adjustable-rate mortgage into a fixed-rate mortgage. Both options will result in bigger savings and a more stable interest rate.
Disadvantages of an Adjustable-Rate Mortgage
- Increased payments – The possibility for higher monthly payments is the primary drawback of adjustable-rate mortgages.
- Budget – Predicting and budgeting for mortgage payments may be difficult, increasing the risk that a household’s financial stability will suffer.
- Things may not go as planned – Being optimistic is ideal, but even with careful planning, you might not be able to sell or refinance your loan when the fixed-rate term ends. You could be trapped with the ARM even though you’ve done everything right. Or worse, you could risk foreclosure if you cannot afford higher mortgage payments.
- Complexity – Some borrowers may not be aware of what they are getting into because of the complex loan structure.
How to Apply for an Adjustable-Rate Mortgage
Like any type of loan, ARMs come with their own requirements, including:
- Credit score: For a conventional ARM, your credit score must be at least 620. An FHA ARM requires a minimum score of 580.
- Debt-to-income (DTI) ratio: To qualify for an adjustable-rate mortgage, your DTI should not be higher than 50%.
- Down payment: In most cases, a down payment of at least 5% of the property’s price is needed to get an adjustable-rate mortgage, however, certain government-backed mortgages (such as VA loans and FHA loans) may permit a smaller down payment.
- ARM loan amount: Though it varies by location and property value, a borrower with a conforming adjustable-rate mortgage may often get financing for a single-family house up to $647,200. Some ARMs, however, may let you borrow up to $970,800 for expensive properties.
Apply Today With Total Mortgage
Finding the perfect home can be a challenge, but finding the ideal mortgage that fits your needs and budget can be an even bigger one. Working with a mortgage lender attentive to your financial goals and situation is critical when it comes to finding the loan that best suits your needs.
When you’re ready to take the first step toward finding the right adjustable-rate mortgage, consider Total Mortgage as your mortgage lender. Start by finding a Total Mortgage branch nearest to you or apply online and get a free rate quote.
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