ARM's (What is an Adjustable Rate Mortgage?)

An ARM or adjustable-rate mortgage has numerous pros and cons. ARMs are an alternative for home financing, where the interest rate is likely to fluctuate with time, especially when the benchmark interest rate changes. These are better than fixed-rate mortgages as the initial rates are lower. However, with periodic adjustments in interest rates, the borrower's monthly payments can increase or decrease.

Borrowers choosing an adjustable-rate mortgage should understand if it is the right choice for them or not. 

If you need more details about an adjustable-rate mortgage, types, adjustable-rate mortgage pros and cons, and what factors directly affect an adjustable-rate mortgage, continue reading this post.

Under What Conditions Is the ARM the Right Choice? 

• If you have plans to sell the property in a few years or refinance it after some time, an adjustable-rate mortgage is a viable option. It means that you take advantage of the introductory terms, and then, as the rate hikes, you can sell or refinance.

• If your income will increase after a specific time, ARMs can be a good choice. That's because the initial rates in ARMs are relatively low compared to fixed-rate mortgages. 

• Another condition in which an ARM is a viable option is when you purchase an investment and sell it later.

• Similarly, if you can pay off the entire loan as a short-term debt in five years, you can go in for an adjustable-rate mortgage.

However, if you know that you will not sell or refinance the property for the entire duration of the mortgage, ARMs might not be the best idea. Also, if you expect your financial condition to stay the same in the future, it's best to stick to a fixed-rate mortgage.

Types of Adjustable-Rate Mortgages

ARMs differ based on -

• Their duration

• Frequency of rate change and 

• Repayment of the loan

The common types of ARMs are -

• Interest-only adjustable-rate mortgage

In this type, the borrower pays the interest in the initial phase. During this time, the principal amount is not paid. After the initial term ends, the balance principal is repaid with increasing monthly payments. 

• Hybrid ARMs

In this type, the interest rate is fixed for a set of years, for example, 5 or 10 years. The interest rate is adjusted after the agreed time passes. Typical examples are - a 5/1 adjustable rate mortgage where the rate is fixed for the initial five years, and after that, the rate is adjusted each year. Another example is the 7-year adjustable-rate mortgage rate, which is fixed for the initial seven years, with the rates getting adjusted every year. Similar is the case with 10-year adjustable rate mortgage rates or a 3-year adjustable rate mortgage.

• Payment Option Adjustable-Rate Mortgage

Borrowers can choose from payment options like interest-only, limited, or standard payments. 

Adjustable-Rate Mortgage Vs Fixed Mortgage

Adjustable-Rate Mortgage Pros and Cons

Here's a rundown of the pros and cons of ARMs. 

Pros

• The initial rate of interest is low compared to fixed mortgage rates.

• There is always the chance that the rates can drop further.

• ARMs are a good choice when you are considering investing in a property. It helps build equity fast.

Cons

• In most cases, the monthly payments increase with time.

• Instability and uncertainty of rates can make things more challenging financially.

• The possibility of rates increasing even with a drop in the index remains.

• USDA loans are not available on ARMs.

• Even with monthly payments, the balance due becomes larger.

What Factors Directly Affect an Adjustable-Rate Mortgage?

Some of the factors that impact ARMs are -

1. Index Rate: ARMs are directly related to the index rate. It means that fluctuations in the index can impact the ARM interest rate.

2. Lender's Margin: This is a constant throughout the loan duration and is a fixed percentage that lenders add to the index rate.

3. Initial Fixed-Rate Period: The interest rate remains the same for a set time. For example, in the case of a 7-year adjustable-rate mortgage, the interest rate is fixed for the first seven years.

4. Interest Rate Adjustment Period: Once the initial period is over, the interest rate changes or adjusts periodically throughout the loan term.

5. Interest Rate Caps: An ARM must be carefully studied before selecting one to finance your home. Before making a choice, you must also understand how much the interest rate will likely change. This is called a cap or limit, and borrowers choosing an adjustable-rate mortgage should know about three of these caps -

• Lifetime Caps are the maximum rate of interest that you'll need to pay during the loan term.

• Periodic Caps are limits on the interest rate in one adjustment period.

• Payment Caps are the limits on the monthly payments. Remember that even though you make monthly payments, the total due amount will increase.

For most people, an adjustable-rate mortgage is a riskier option than fixed mortgage rates. That's because there is instability and inconsistency in the mortgage payments, with the chances of future payment amounts being increased. It is recommended that you speak to a professional before choosing ARMs. 

To summarize, ARMs are another home financing option with the advantage of a lower interest rate in the initial years, followed by fluctuating rates for the rest of the term. It is easier to get an ARM vis-a-vis a fixed-rate mortgage. Since there are inherent risks in adjustable-rate mortgages, it is best to take expert help before finalizing the options.