ADJUSTABLE RATE MORTGAGE

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What is an Adjustable-Rate Mortgage?

An adjustable rate mortgage (ARM) is a mortgage loan with a fixed note and interest rate that is adjusted periodically based on an index based on a cost of funds for the lender to borrow money from the credit markets. The loan is typically offered at the lender’s standard variable rate/ base rate. There might be an index the rate is tied to or not and could be adjusted at the lenders discretion.

This type of loan can save you thousands on your monthly payments and is great if you know your planning to move in 5, 7 or 10 years.

How it Works

  • Currently, there are 3 different terms for adjustable-rate mortgages. There is a 5-year fixed, 7-year fixed and 10-year fixed mortgage loans. Once the term is expired, interest rates can adjust up or down depending on the index it is based on.
  • Typically, there is a cap of 5% for any rate adjustments above your initial rate.
  • You can be eligible for no prepayment penalties.

Advantages

Adjustable rate mortgages (ARM) are a less expensive option when buying a house especially if you are only planning on living there a short period of time. The primary benefit is taking advantage of falling interest rates without having to refinance with additional closing costs and fees.

Adustable rate mortgage

Disadvantages

Interest rates go up and down and your payments can go up dramatically at any time making it difficult to plan and estimate your yearly payments.

How often does an adjustable-rate mortgage adjust?

Typically, an adjustable-rate mortgage adjusts after 3 years. This rate can adjust every year once a year after the first 3-year period. The same applies for 5 year or 7-year ARM an ARM is defined as adjustable-rate mortgage. This means it adjusts after the initial term of the fixed term whether its 5 or 7 years.  When the rate goes up, your payment goes up so please be aware of what the adjustable rate is after the fixed term, and it’s typically tied to an index. The index is what is the base rate plus a variable adjustment on a yearly basis after the initial fixed term.

What are the risks of an adjustable-rate mortgage?

The biggest risks are the rising monthly payment and payment shock once the loan goes adjustable. Additionally, there could be negative amortization, pre-payment penalties and falling housing prices.

Who is eligible for a fixed rate mortgage?

Typically, borrowers with a FICO score of 720 or higher get approved for an adjustable-rate mortgage. Additionally, there might be other financial requirements such as assets in reserves usually 6 months reserves. Reserves can be in a checking, savings, or 401K/retirement account.

 

Do ARM rates go down?

ARM – adjustable-rate mortgages is a loan with an interest rate that changes after the initial fixed term. Your payment most likely won’t go down at all. It really depends on what index your rate is based on and whether the financial markets are in a rising rate time period or declining rate period. You could end up owing more money than you initially borrowed depending on the type of loan your in. Negative amortization loans typically result in borrowers owing more than their principal loan borrowed.

 

Do you pay principle on an ARM?

If the ARM is an interest only adjustable-rate mortgage, then you only pay interest only. There is no reduction in mortgage balance during the term of the adjustable rate. The interest rate could adjust during the term of your loan so please read the fine print. After the initial fixed term of the adjustable-rate term, loans typically go to principal and interest. This results in a higher payment and in some cases can present sticker shock to a borrower. At that time, the borrower may want to consider refinancing into another ARM or long-term fixed rate loan.

 

Is an adjustable-rate mortgage a bad idea?

It depends, an adjustable-rate mortgage is a mortgage that adjusts based on market conditions. They are not recommended because there’s no predictability in market conditions and job stability. There’s also risk when the rate goes up after the fixed period that your payment goes too high, and you cannot afford the new monthly payment resulting in losing your home.

Can I pay of an adjustable-rate mortgage early?

Depending on if you have a prepayment penalty determines whether you can pay off an adjustable-rate mortgage early. Typically, loans have 2-to-3-year prepayment penalty. Sometimes lenders offer a higher rate or charge points up front to eliminate the prepayment penalty.

If I make additional payment to the mortgage, does it help?

Yes, if you make an additional payment to your mortgage could significantly reduce the term of your loan.

What is an example of an adjustable mortgage rate?

The adjustment period is the period between the rate changes. When looking at ARM options and you see 5-year ARM or 1 year ARM, the 5-year ARM is adjustable after the first 5-year period. In the case of the 1-year ARM, the adjustable-rate period starts after the first year of the loan.

What are CAPS in an adjustable-rate mortgage?

CAPS in an adjustable-rate mortgage are meant to protect the borrower and ensure the banks mitigate their risk. There are two types of CAPS, there’s a periodic cap and a lifetime cap. The periodic cap limits how much your rate can change in a specific period such as a 1-year period. A lifetime cap is the cap at which the ARM rate can change over the period. Let’s assume you have a periodic cap of 2% per year. The interest rates rise by 3% in one year for example, but if the cap is 2% then the cap is 2%. Your protected by the cap and not subject to increase in the market and limited to the cap of 2% increase.

Summary

Adjustable-rate mortgages are a flexible option for borrowers to maximize their home purchase while minimizing their monthly installment, but it comes with the risk of adjustments. We recommend read the fine print, understand the indices that dictate the adjustments and when your adjustment period starts and ends.

Questions?

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