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What is an adjustable rate mortgage?

There are many things to consider when applying for a home loan. One of the first decisions is whether to get an adjustable-rate or a fixed-rate mortgage. Each has its advantages and disadvantages. It's important to consider your risk tolerance, budget and housing needs when making this decision.

Adjustable-rate mortgage defined

An adjustable-rate mortgage (ARM) is a loan where the interest rate is fixed for a specific amount of time, then adjusts periodically. The initial interest rate is usually lower than that of fixed-rate mortgages. Once the fixed-rate period ends, an ARM's interest rate will adjust depending on the index it uses. This means your monthly payments can increase or decrease.

Indexes are set by the financial industry and are used to establish rates used by lenders. There are several indexes to choose from, and loan paperwork will identify which index your mortgage follows.

Interest rates are impossible to predict. In recent decades, trends see them increasing and decreasing over multi-year cycles.

Advantages of an adjustable-rate mortgage

  • Initial interest rates and payments are typically lower than for a fixed rate loan. Lenders may consider lower payments when qualifying borrowers.
  • If you have an adjustable-rate mortgage, you may be less likely to need to refinance to benefit from falling rates. This eliminates new closing costs and fees that come with refinancing. When rates drop, ARM borrowers see their interest rate and monthly payments decrease.
  • With lower rates at the beginning of the loan meaning lower payments, homeowners may be able to set money aside to use for other things.

Disadvantages of an adjustable-rate mortgage

  • Rates and payments can increase significantly during the loan term. This could negatively affect your budget.
  • Loan adjustments are based on a pre-determined schedule , so you may miss out on a period of lower interest rates.
  • Annual caps don't always apply to initial loan adjustments. This can make the first adjustment costly.
  • ARMs are complex. Lenders may have a lot of different products available that offer varying adjustment indexes, margins and caps. It can be easy for you to become confused and locked into a loan you don't fully understand.

Different types of adjustable-rate mortgages

Lenders can structure ARM loans in several ways, as long as they meet federal lending laws. The result is a variety of adjustable-rate mortgages. Examples of ARMs currently available include:

  • The 7/1 ARM. The interest rate is fixed for the first seven years. It adjusts each year after that, starting with year eight.
  • The 5/1 ARM. The interest rate is fixed for the first five years. It adjusts each year, starting with year six.

Things all ARMs have in common

Adjustable-rate mortgages have several key features in common. These include:

Index

Each adjustable-rate mortgage is attached to an index. This index determines what the interest rate does after the initial fixed-rate period. Most ARM loans use the Secured Overnight Financing Rate (SOFR) or the 11th District Cost of Funds Index (COFI).

Margin

ARM lenders add percentage points to indexes to set the interest rate. This determines the rate you'll pay during the life of the loan. Lenders must disclose this margin to you before you sign.

Caps

Regardless of the type of ARM you choose, you're potentially at risk of rising interest rates. However, there are limits, or caps, on how much interest rates can increase.

Adjustment caps limit how much interest rates can increase at each adjustment date, while lifetime caps limit how much interest rates can increase over the life of the loan. Your lender must share these caps with you when you're applying for a loan.

What is a fixed-rate mortgage?

Fixed-rate mortgages have the same interest rate throughout the life of the loan. This means the principal and interest portion of your monthly payment doesn't change.

Fixed-rate mortgages are the most popular kind of loans because of their predictability and stability. Lenders generally charge higher interest rates with fixed-rate mortgages than with ARMs, which can limit how much borrowers can afford.

Advantages of a fixed-rate mortgage

  • Interest rates stay the same.
  • Stability makes it easier to budget. With consistent principal and interest payments, you could manage your money with more certainty.
  • Fixed-rate mortgages are easy to understand, making them ideal for first-time homebuyers.

Disadvantages of a fixed-rate mortgage

  • You'd need to refinance to take advantage of any lower interest rates in the future. This means paying closing costs and fees again.
  • Fixed-rate mortgages can be harder to qualify for than ARMs.
  • You might pay more in interest during the life of the loan depending on what interest rates do.

Types of fixed-rate mortgages

Like adjustable-rate mortgages, there are several types of fixed-rate mortgages to choose from. The more common ones include:

15-year fixed-rate mortgages

Lower interest rates make this an attractive option. You can pay off the principal amount faster than with a 30-year loan. This can help you build up equity quickly. Keep in mind that fifteen-year mortgages do have higher monthly payments.

30-year fixed-rate mortgages

This is the most affordable fixed-rate mortgage. Even with a higher interest rate, monthly payments are lower since your payments are spread out over 30 years.

This is a good loan for individuals planning to stay in the home for many years. Lower monthly payments are also attractive to borrowers with lower incomes.

ARM vs. fixed: which should I choose?

It's essential to know the differences between adjustable-rate and fixed-rate loans in order to select the one that works best for your situation. Here are some questions to consider when deciding on a loan type.

How long do you plan to stay in the home?

Are you only planning to live in a home for a few years? If so, the lower rates of an ARM may be more ideal. Lower payments may help you to save money for your next home. You can then sell before the fixed-rate period ends which can help you avoid potentially large rate adjustments.

How frequently does the ARM adjust? When is the adjustment made?

Once the fixed period ends, most ARMs adjust annually. This adjustment usually happens on the anniversary of your loan. The index value 45 days before the anniversary will determine the new rate. Some ARMs adjust every month, though. It's important to know how often adjustments happen. If the volatility is too much, a fixed-rate mortgage is probably a better option.

What's the interest rate environment like?

If interest rates are high, an ARM might make the most sense. The lower initial rate allows a borrower to enjoy the benefits of homeownership. And if rates fall, your payments may be lower without refinancing. If rates are currently low, fixed-rate mortgages are usually a better

Can you still afford your monthly payment if interest rates rise?

If your interest rate increased, your monthly payments could go up significantly. Consider whether you can afford this payment increase. It's important to know what would be the highest payment you could ultimately have to pay.

Buying a new home is exciting. And choosing the right type of mortgage for your needs doesn't have to be overwhelming. Our home lending advisors can help. They'll explain your options, make sure you understand how each one works and help you decide which mortgage is best for you.

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