Understanding an Adjustable-Rate Mortgage (ARM)

Thinking of taking out a mortgage but don’t know what an adjustable interest rate is and if it’s better than a fixed one? Well, an adjustable-rate mortgage by definition is a type of home loan that starts with a fixed-rate period. After that initial period ends, the interest rate on your loan will likely change based on market conditions. In this article, we will explain everything you need to know about ARMs, from the different types available to how the interest rates are calculated.   

A house loan known as an adjustable-rate mortgage, or ARM for short, has an interest rate that is not fixed but fluctuates over the course of the loan. Many homebuyers opt for this type because it can offer them lower interest rates than fixed-rate mortgages and consequently lower monthly payments. Nonetheless, there is more to them than just this so therefore it’s crucial to comprehend how they function in detail before registering for one. 

As we already said, the initial interest rate will be much lower but after this period, which typically last for a couple of years, ends, the interest rate will increase or decrease and continue to change. 

With that being said that doesn’t mean your payment can just go through the roof, as there are caps that limit how high your interest rate can go during the life of the loan.  

If you’re thinking about going with an ARM, make sure to talk to your lender first to fully grasp how it operates before making a decision. 

What Exactly Is an Adjustable-Rate Mortgage?

Once you decide it’s time for you to settle down and buy a house, you may start researching different mortgage types available to you. If you end up taking out a home loan with adjustable mortgage rates, what this essentially means is that there is no percentage you and your lender agreed upon beforehand.  

The risk with this is that your monthly payments could increase if interest goes up, but in the beginning, the payments will be a lot more affordable.  

How Does an Adjustable-Rate Mortgage Work?

Now that we answered what is an adjustable-rate mortgage, let’s take a look at how it works.  

Once you decide to take out a mortgage with an adjustable rate, you will be offered quite a low-interest fee. Because this is not fixed and something you and your lender agreed upon, the price will vary through the term. This means your monthly payments will likely go up or down over the life of the loan.  

If you would like to sell your house or refinance before the interest rate rises, ARMs are a tempting offer considering they start out with a lower interest rate. Be cautious though, as your interest rate will eventually increase and you can find yourself paying more in interest than if you had simply chosen a different option. 

So, how are they calculated? Well, one of the most common ways of calculating is when the interest rate on your ARM is tied to an index, which lenders use to set rates. This index is the London Interbank Offered Rate (LIBOR).  

For example, in this case your adjustable-rate mortgage would be calculated like this: the index plus a margin equals your interest rate. Let’s say the LIBOR is 3% and your margin is 5%. The total interest rate you would need to pay is 8%.  

This rate will stay at 8% for a certain period of time, usually a couple of years. After that, it will likely change. 

This is not the only way for calculating, so be sure to ask your lender what they use and how everything works just so you are not in the dark about these changes.

Adjustable-Rate vs. Fixed-Rate Mortgage: What’s the Difference?

When it comes to mortgages, if we look at the interest rate, there are two main types: fixed vs adjustable-rate mortgage. As the name already implies, fixed-rate mortgages have a set interest rate for the life of the loan while ARMs have an interest rate that can change over time.

Different Types of Adjustable-Rate Mortgage

There are many different home loans that offer adjustable interest rates. Here, we will take a look at some of the more popular types so you can make an informed decision down the road.

Hybrid Adjustable-Rate Mortgage

A hybrid adjustable-rate mortgage is a type of home loan that offers borrowers the stability of a fixed-rate mortgage while also allowing them to take advantage of lower interest rates when they occur.  

The initial interest rate on a hybrid ARM is usually lower than the rate on a fixed-rate mortgage, but it can adjust upward or downward over time as market conditions change. Payment changes here are capped at specified limits, so borrowers know in advance how much their payments could increase or decrease.  

These loans are often used by borrowers who plan to sell their homes or refinance before the interest rate starts to adjust. They can also be a good choice for borrowers who want the predictability of a fixed-rate mortgage but still want some of the benefits of the adjustable-rate mortgage as well. 

Interest-Only Adjustable-Rate Mortgage

A type of adjustable-rate mortgage known as an interest-only mortgage gives borrowers the option of paying only the interest and not the principle. Typically, this continues for the first few years. The payments will include both interest and principal after the introductory period is over.
People who expect an increase in their income over time and are willing to pay more in the future often choose this option.

Payment-Option Adjustable-Rate Mortgage

This mortgage type gives borrowers the flexibility to make low initial interest payments, which can help them afford bigger payments towards the house than they would be able to with a fixed-rate.   

The interest rate on this mortgage is tied to an index, plus a margin. The index used is the one we already talked about, but your lender could also be using the Treasury Bill Index or the Cost of Funds Index so be sure to ask.  

Most borrowers who pick this kind of ARM do so because they anticipate an increase in their income in the future and because they want the freedom to make lower payments in the initial years of the loan. 

Interest-only, minimum payment, completely amortizing 30-year, and fully amortizing 15-year payments are the four common payment options offered by these mortgages. 

Adjustable-Rate Mortgage Pros and Cons

If you’re now sold on an adjustable-rate mortgage, it’s important to also look at both the benefits and drawbacks before signing on the dotted line.  

Pros  

• Lower interest rate during the initial period so you can save money in the short-term  
• Can help you qualify for a larger loan amount  

• There is more flexibility in how you plan your finances. You can choose to make extra payments on your ARM in order to pay it off more quickly.   
• You can save money on the interest if you are planning on selling your home before the initial period ends.   

Cons  

• Payments could increase if interest rates rise. There is also the possibility of interest rates rising sharply so you could end up owing more on your mortgage than your home is actually worth.  
• It may not be suitable for everyone  

• If you decide to sell your home before the end of your loan term, you may not be able to get out as much money for it as you would have if you had a fixed-rate mortgage.   
• ARMs are complex and have many rules and fees. All these factors can make these loans risky for borrowers who don’t fully understand what they’re getting into.

When Does an Adjustable-Rate Mortgage Make Sense?

Adjustable-rate mortgage loans can make sense if you took the time to fully understand what you are getting yourself into. They are also a good option for borrowers who are expecting their incomes to rise in the future and just want their initial monthly payments to stay as low as possible. On the other hand, borrowers who intend to stay in their homes for an extended period of time may not be a suitable fit for ARMs because rates on these loans might increase with time.

Bottom Line

If you’re thinking of buying a home, all the things that go into it can get confusing pretty fast. Committing to this long-term loan should not be taken lightly, so be sure to carefully consider everything before making any decisions. Adjustable-rate mortgages can be a great option for borrowers who are looking for a lower initial interest rate. Just be sure to understand how these payments change over time so you don’t get surprised down the road when a bigger bill arrives.  

We advise you to hire a financial advisor to help you find the best adjustable-rate mortgages that you can qualify for.