When you’re buying a home, you’ll want to consider how soon you’ll sell it and move on. Knowing how likely you are to move, upgrade, or downsize within the next 10 years, can help you decide if an adjustable-rate mortgage is best for you.
Certain mortgages, like an adjustable-rate mortgage, can help you save money on interest in the early stages of your loan due to the low initial interest rates. Adjustable-rate mortgages are not for everyone, so read on to learn more about this option and if it could be right for you.
What is an adjustable-rate mortgage?
As the name suggests, adjustable-rate mortgages (ARMs) have interest rates that may fluctuate. (That’s why ARMs are also known as variable rate mortgages.) Typically, the initial interest rate on an ARM can be lower than a fixed-rate mortgage. But after the initial rate period ends, the loan will enter an adjustable period during which the interest rate can fluctuate and will often rise.
In contrast, a fixed-rate mortgage has an interest rate that’s locked in for the life of the loan .
How do ARMs work?
With the most common type of ARM, the interest rate is set for an initial period — typically, five, seven, or 10 years — before it adjusts incrementally based on the banking index to which it is tied.
You may have seen these types of mortgages referred to as a 7/1 or 7/6 ARM. The first number refers to the length of time (in years) of the initial interest rate. The second number represents how frequently the rate adjusts after the conclusion of this initial period. For example, a 7/1 ARM has an initial interest rate of 7 years, after which it adjusts once per year. A 7/6 ARM adjusts every six months after the initial 7-year interest rate period. These different home loan options can have different benefits to you based on your financial situation, as discussed later.
How are the interest rates of an ARM determined?
After the initial period ends, the interest rate of an ARM will reset based on the benchmark. The new rate of your loan will be based on the benchmark or index, plus a margin. The margin is a defined amount added to the benchmark at each adjustment period, and the rate derived from adding the benchmark to the margin results in the APR that will remain until the next adjustment period. ARMs are generally tied to a benchmark interest rate or index rate that banks charge each other for loans, based on market conditions, such as the London Interbank Offered Rate (LIBOR) or the Securitized Overnight Financing Rate (SOFR). Changes in the index, along with your loan’s margin, determine the changes to the interest rate for an ARM loan, based on the provisions written in your loan documents (mortgage note).
Let’s say you are a borrower with a 7/6 ARM. Your initial rate is 3.4%. So, for the first seven years of the loan, your monthly mortgage payment will be based on an initial interest rate of 3.4%. After the initial period ends, your loan will enter the adjustable rate period and your payments reset every 6 months. If the benchmark index rate for the preceding year was 2% and your ARM margin is +200 basis points (or 2%), your new interest rate would be 4% and your monthly payments would be based on an interest rate of 4%, thus would adjust accordingly.
Every six months thereafter your payments could change again, going up or down according to shifts in the market index rate.
How high can the rate rise?
Caps, an important feature of ARMs, protects you against skyrocketing interest rates. Most ARM loans have caps that limit the total amount that your rate can increase, protecting you against sharp increases when you enter the adjustable period. Reviewing your loan documents can help you figure out whether your ARM loan features an interest rate cap.
Several types of caps exist:
- Initial adjustment cap: limits the total increase during the first adjustment period (typically 2% for 5/6 ARMs and 5% for 7/6 or 10/6 ARMs).
- Subsequent adjustment cap: limits the increase in subsequent adjustment periods.
- Lifetime adjustment cap: establishes the maximum interest rate increase above your initial fixed rate. So, if your initial 5/6 ARM rate was 3% and your lifetime adjustment cap is 5%, your interest rate can never go higher than 8%.
Why have ARMs decreased in popularity?
Historically, ARMs made sense for some homebuyers when interest rates were high. Their initial lower rates, resulting in smaller monthly mortgage payments, made home ownership more affordable for first-time homebuyers, those who might otherwise have been priced out of the real estate market, and those wanting to purchase a more expensive home.
But this lending option has developed a poor reputation because ARMs are associated with higher rates of loan default and foreclosure. It’s really a matter of taking your finances and your needs into account before deciding if an ARM could be the option for you.
ARMs vs. Fixed-Rate Mortgages
The main difference between ARMs and fixed-rate mortgages is that an interest rate for a fixed-rate mortgage is locked in for the life of the loan. Unless you choose to refinance your mortgage, your interest rate will stay the same for the loan’s entire term – whether it’s 15, 20, or 30 years. This could be a good option when you plan to stay in your home for many years or interest rates are low at the time.
Fixed-rate mortgages allow you to plan exactly how much you’ll pay each month throughout the life of your loan. On the other hand, while you can plan for the fixed period of your ARM, you may be responsible for larger (or smaller) payments once you reach the adjustable period of the loan. It’s important to know if you’ll be prepared for a higher monthly payment.
Private Mortgage Insurance
When taking out a mortgage, whether adjustable or fixed-rate, you may have to also get private mortgage insurance (PMI). PMI is an insurance policy for your lender that’s usually required if your loan-to-value ratio (the ratio calculated by dividing the amount borrowed or currently owed by the appraised value of the property) is more than 80%. You can avoid having to pay this extra fee by making a down payment of at least 20%.
If you’re unable to make a 20% down payment, you might consider a first-time home buyer program, like a HomeReady mortgage or an FHA loan. These programs do not offer ARM options but allow you to take out a mortgage with down payments as low as 3%.
Can you pay for points on an ARM?
Some lenders allow you to pay for points on your mortgage, which is basically paying a fee to reduce your interest rate over the term of the loan. Typically, this means you pay the lender some interest upfront and, in exchange, lower your interest rate by a defined amount. In a fixed-rate mortgage, paying points lowers the interest rate over the life of the loan, but in an ARM loan, the lower interest rate will only apply for the initial interest rate period.
While you may want to pay for points on an ARM, you’ll want to first consider if it’s worth the money. For example, if you plan to refinance early, paying a fee upfront to reduce your interest rate might not be of much benefit to you because you only get the benefit of that rate for the initial fixed interest period.
When might an ARM make sense?
Despite their recent history, ARMs may make a lot of sense for some borrowers.
Perhaps you bought a house while you are completing graduate school, a professional training program, or military service, but plan to move once you’ve completed the program. Or maybe you are expecting an increase in your earnings in the not-too-distant future and anticipate being able to afford a higher payment. If you plan to sell your home before the expiry of the initial rate period of an ARM loan, you might consider if this a sensible option. In these scenarios, you may benefit from lower monthly payments during the initial rate period.
An ARM might make it possible for you to afford a more expensive home than you would be able to otherwise, since you may have lower initial monthly payments compared to a fixed-rate loan.
The home-buying process can be full of twists and turns. But we’re here to help you navigate them with confidence.
Ready to figure out which home loan option best fits your needs? Learn more about Ally Home Loans.