When interest rates are increasing like they have been this year, many people start thinking about adjustable rate mortgages (ARM). Every homebuyer is different and when it comes to looking at mortgages, you want to understand all types of mortgages. It’s common to hear people talk about conventional and FHA mortgages, but not as many talk about ARM’s. Plus, ARM’s got a really bad name a few years ago! Here is some information to help you decide if an ARM might be good for you.
What is the difference between an ARM and a fixed rate mortgage? The main difference is in the interest rate structure. A fixed rate mortgage will stay the same for the entire term, many people like that stability, knowing the principal and interest part of their payment will not change. An ARM typically offers a lower initial interest rate but after a certain time period, the interest rate will usually increase.
An adjustable rate mortgage is sometimes referred to as a variable rate mortgage. Most ARM’s use a hybrid model combining a lower starting rate and then scheduled rate adjustments over the remaining term. The rate adjustments are calculated using an independent financial rate index such as the Secured Overnight Financing Rate (SOFR) plus a margin set by the lender at the loan initiation. Most ARM’s also have a cap limit per adjustment period and also an overall cap for the full term.
What types of ARM’s are available? There are several types of ARM’s available. The most common ones are 3/1, 5/1, 7/1 or a 10/1 – there are also 5/6 and 7/6 ARM’s. The first number represents the period during which your interest rate will be fixed. The second number is how often your rate will adjust after the initial fixed period expires. So a 3/1 ARM means that your initial rate is fixed for 3 years and then your rate will adjust once a year. A 3/6 means that your rate is fixed for 3 years and then it will adjust every 6 months.
What happens to your interest rate after the initial fixed rate period? Your rate can increase or decrease – it depends on the current rate and index at the time it adjusts. If your ARM is a 5/6 with a 2% cap, it means your rate is fixed for five years. After the 5th year, your rate will adjust based on the index but there is a 2% cap – meaning the rate cannot increase or decrease more than 2% per adjustment. Some ARM’s also have a lifetime cap of 5 or 6%, meaning if you start with a 5% rate, the maximum your interest rate can go to is 10 or 11%.
Why should you consider an ARM? Many homebuyers are looking for a lower payment and an ARM can give them that. Frequently a homebuyer knows that they will only be in this home for a short time – maybe 4-6 years. In that case, an ARM may make sense. If you have a 5/1 ARM and plan to move in 4-5 years, your interest rate will not change until after the 5th year. Also if rates are lower, there is a chance your interest rate could drop in the future.
Talk to your loan officer and make sure you understand the loan and what changes you can expect in the future. For some homebuyers, it can make the difference in keeping a payment lower, at least to begin with. It may be a loan you want to consider or it may not – but at least you will have looked at all options!