An adjustable rate mortgage (ARM) is a mortgage in which the interest rate changes throughout the term of the loan. Most ARMs have a fixed interest rate for a set period. After that time passes, the interest rate resets, often on an annual basis, but sometimes, the adjustments happen every five years or on another unique schedule.
These adjustments could cause the interest rate on the mortgage to fall or rise, depending on the index to which the loan is tied. Wondering if an adjustable rate mortgage is right for you? Here’s what you need to consider.
How does the rate adjust?
ARMs are tied to a set margin, which is used along with the index to calculate the mortgage’s new interest rate. Mortgages are usually tied to one of three indexes: the maturity yield on one-year treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate (LIBOR).
To explain how this works, let’s say your adjustable rate mortgage is tied to the LIBOR index, and it has a margin of 3%. When you take out the loan, the LIBOR is 1% so your interest rate is 4%. That’s the LIBOR rate plus your margin of 3%. When your adjustable rate mortgage resets, the LIBOR is 2%. At that point, your interest rate increases to 5%.
Why choose an adjustable rate mortgage?
The low introductory interest rate that adjustable rate mortgages offer is attractive to many borrowers. Depending on the loan, the introductory rates can last from one to 10 years, and borrowers often use an ARM when they plan to sell a property before the introductory interest rate expires. In other cases, borrowers opt for an ARM when they want the low introductory rate and they feel confident about their ability to refinance if the rate increases.
Can adjustable rate mortgages become too expensive?
While there are risks in taking out an ARM, borrowers are still protected. Most ARMs come with rate caps, which limit how much the interest rate can change. Periodic rate caps dictate how much the interest rate can change in the short-term. Lifetime rate caps limit how much the interest can increase during the life of the loan. Before taking out an adjustable rate mortgage, you should talk with your lender about these caps so that you know what to expect.
When should you avoid an adjustable rate mortgage?
Although adjustable rate mortgages are great for a range of situations, they aren’t ideal in every scenario. If you plan to live in your home for the rest of your life, you may want the stability of a fixed-rate mortgage. Often, the introductory interest rate will be higher on this type of loan, but that may be worth it to avoid an unpredictable adjustment. Additionally, if you want a loan guaranteed by the FHA or the VA, you can’t choose an ARM in these situations.
Choosing the right type of mortgage can be tricky, but we try to make it easy for you. If you would like to explore adjustable rate mortgages or other mortgage products available from Capital Mortgage Advisors, please call us at 800-859-5648, or complete our simple form below. One of our experienced mortgage specialists will contact you.