August 21st, 2023
Getting a home loan is one of the most important financial decisions you will ever make. Consequently, it is imperative to get the best type of loan for your specific situation. And that entails learning about the different types of mortgage loans available - including adjustable-rate mortgages.
In this article, we will explain everything you need to know about adjustable-rate mortgages. By the end, you will understand how they work, how the rates are calculated, the different subtypes of adjustable rate mortgages that exist, and their advantages and disadvantages. We hope this article will help you make the best possible decision - so let’s not delay and start right away.
An adjustable-rate mortgage (ARM), also called a floating or variable-rate mortgage, is a type of mortgage loan where your interest rate is fixed for an initial period, typically 5, 7, or 10 years, then adjusts periodically based on market conditions.
In other words, during the initial fixed-rate period, your monthly payment remains the same. After that, your rate can go up or down, depending on factors like the benchmark rate, and consequently your monthly payments change.
Importantly, ARMs typically have rate caps to protect you from significant payment increases. An adjustable-rate mortgage can be a suitable option if you plan to sell or refinance before the initial fixed-rate period ends. Do your research and consult with experts to determine if an ARM is the right financial decision for you.
A fixed-rate mortgage has an interest rate that remains the same throughout the entire loan term, so your monthly payment will also remain constant. This provides stability and predictability, which can be advantageous if you prefer to have a consistent monthly payment and budget accordingly.
On the other hand, as we've mentioned, an adjustable-rate mortgage has an interest rate that can change over time. Typically, ARMs start with a lower initial interest rate during an introductory period, often lasting a few years. After this period, the rate adjusts periodically based on market conditions and other factors.
These rate changes are the main difference between fixed-rate mortgages and ARMs - for the former, the rates remain consistent through the life of the mortgage, and for the latter, the rates change after the initial fixed period.
Now, let's break down how ARMs work in simple terms.
When you are taking out an adjustable-rate mortgage, you negotiate the duration of the fixed period, where your monthly payments are consistent, and how often the rates adjust after the fixed period is over. For example, let's say you get a 30-year mortgage loan, with a fixed period of 5 years and agree that your rates will be adjusted every year after that.
This type of ARM is often denoted as a 5/1 ARM (the first number signifies the fixed period and the second how often the rates are adjusted). The rates are adjusted every year based on the fully indexed rate.
The fully indexed rate is the sum of a benchamark index that represents the current market conditions (more on this later) and an ARM margin. The ARM margin is a percentage your lender adds to the index to calculate the fully indexed rate, which will determine your monthly payments.
The ARM margin is a number you negotiate with your lender and it typically stays consistent through the life of your mortgage. The exact number depends on the lender, your credit score, payment history, etc. - in other words, all the typical factors that otherwise determine your mortgage rates.
So, the adjustable/variable part of your monthly payments during the adjusted period is the benchmark index.
The variable rate on an ARM is tied to a benchmark rate that is influenced by market conditions and changes over time. The most widely used benchmark rate until 2020 was the London Interbank Offered Rate (LIBOR). Due to certain controversies surrounding LIBOR, it was slowly phased out and replaced.
The most common benchmark rate currently used in the US for pricing loans in dollars is the Secured Overnight Financing Rate (SOFR). When you add the index, which is based on the benchmark rate, to the ARM margin, which you negotiated with your lender, you get the actual rate you need to pay on your outstanding mortgage balance.
Another key characteristic of variable mortgages are the rate caps. ARMs typically have two types of rate caps: annual caps and lifetime caps. The annual cap limits how much your interest rate can change in a single adjustment period, usually one year.
For example, if your initial interest rate is 3% and your annual cap is 2%, your rate can't rise above 5% in the first adjustment period, even if it should based purely on the fully indexed rate.
On the other hand, the lifetime cap puts a maximum limit on how high your interest rate can go over the life of the loan. It provides long-term protection against drastic increases and ensures that your payments remain manageable.
For example, let's say your ARM has a lifetime cap of 6%. If your initial rate is 3%, no matter how much the market changes, your interest rate can't exceed 9% throughout the entire loan term.
These rate caps give borrowers peace of mind by limiting the potential impact of market fluctuations on their monthly payments. When considering an ARM, it's crucial to carefully evaluate the rate caps and ensure they align with your financial goals and risk tolerance.
Some people take out an ARM loan because it typically has a lower interest rate during the fixed period compared to fixed-rate loans, with the intent of refinancing the mortgage when the adjusted period starts. Refinancing an ARM involves replacing your existing loan with a new loan that offers better terms.
This can include a lower interest rate, a longer loan term, or even changing from an adjustable-rate to a fixed-rate mortgage, as was mentioned. If you're concerned about future rate increases and want the stability of a fixed monthly payment, refinancing to a fixed-rate mortgage can give you peace of mind.
Another common reason to refinance an ARM is to lock in a lower interest rate. If you initially took out your ARM when rates were high but now rates have dropped, refinancing can help you secure a more favorable rate and potentially reduce your monthly payment.
When refinancing an ARM, it's important to consider the costs involved, such as closing costs and fees - because there are always fees when refinancing any type of mortgage, be it a conventional, government-backed, or any other type of mortgage.
These expenses can vary depending on the lender and loan terms, so it's essential to compare offers from different lenders to ensure you're getting the best deal.
Until now, we have discussed what adjustable-rate mortgages are and how they work, but there are 3 different subtypes of ARMS that you should also take note of:
With a hybrid ARM, you enjoy a fixed interest rate for an initial period, typically ranging from five to ten years. This means that your monthly mortgage payment remains the same during this initial period, providing predictability and enabling you to budget effectively.
After the initial period, the interest rate on your hybrid ARM will adjust periodically, typically once a year, based on the factors that we discussed above. This is the most common type of adjustable-rate mortgage and was the one we used as the representative when discussing ARMs.
With an interest-only ARM, you will only be required to make interest payments during the fixed period. This can result in lower monthly payments compared to a traditional mortgage. After the initial period, the interest rate on your mortgage will adjust periodically, like with other variable mortgages.
It's important to note that with an interest-only ARM, your monthly payments will increase after the initial period ends. This is because you'll start paying both the principal and interest on the loan. It's crucial to carefully evaluate your financial situation and future plans before opting for an interest-only ARM.
If you're seeking even more flexibility in your mortgage payments, you might want to consider a payment-option adjustable-rate mortgage (ARM). This type of mortgage gives you multiple payment options each month, allowing you to choose the amount that works best for your budget.
With a payment-option ARM, you have the choice to make minimum payments, interest-only payments, or fully amortizing payments. Minimum payments are the lowest option and typically only cover a portion of the interest due, resulting in negative amortization. Interest-only payments cover just the interest, and fully amortizing payments cover both the principal and interest, similar to a traditional mortgage.
The flexibility of a payment-option ARM can be beneficial if you have varying income streams or if you want to have more control over your monthly cash flow. However, it's crucial to understand that making minimum payments or interest-only payments can lead to negative amortization.
This means that the outstanding balance of your loan may increase over time instead of decreasing. And you will always have to pay off your lender by the time it is stipulated in your mortgage contract, so while payment-option ARMs may sound appealing due to their flexibility, they can cause long-term financial distress if you only make minimal payments.
Let's provide a summary of the pros and cons of adjustable-rate mortgages.
Considering these pros and cons, it's essential to evaluate your financial goals, future plans, and tolerance for potential payment changes before deciding if an adjustable-rate mortgage is right for you.
If you are reading about adjustable-rate mortgages because you wish to purchase a new home, know that the home-buying process doesn’t end there. Even after you qualify for a loan, find a property you like, and negotiate the terms with the seller, you still need to go through the bureaucratic process.
That’s where Lightspeed Escrow can help. We are a team with a background in real estate that provides quick and accurate escrow services. We can make your real estate transaction go as smoothly as it can.
If you have any questions about how the escrow process works or how our services can help in your specific situations, feel free to contact us to speak with one of our experts.