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How does an adjustable-rate mortgage work?

The initial rate and payments during the first few years can be significantly different from rates and payments later in the loan’s term. Before committing to an adjustable-rate mortgage, ask your lender for an annual percentage rate (APR). If this rate is higher than the initial rate, it is safe to assume that your rate and payments will be a lot higher when your initial period is over, even if interest rates are stable.

ARMs have an adjustment period where the interest rate and monthly payment changes. These adjustment periods can occur every month, quarter, or year. For example, a loan with an adjustment period of one year is called a one-year ARM, and the interest rate and payment can change once every year; a loan with a five-year adjustment period is called a five-year ARM, and so on.

The interest rate for an ARM depends on two main components: the index and margin. The index measures the interest rate and the margin is an extra amount your lender adds. Your monthly payments will be influenced by any caps, limits, or how high or low your rate is. For example, if the index goes up, so will your interest rate, and most likely, your monthly payments. If the index goes down, so will your interest rate and monthly payments.

ARM rates vary from lender to lender. However, most lenders use the same variety of indexes to project an interest rate. For example, the most common indexes include the rates on one-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). On the other hand, some lenders use their own cost of funds as an index. Before picking a lender, ask what index they use and how it fluctuates. This will give you a better idea of what you can expect with that lender and loan.

The margin is an added percentage to the interest rate on an ARM. Just like interest rates, margins can differ from lender to lender, but it usually remains consistent over the term of the loan. The index plus the margin is known as the fully indexed rate. For example, if a lender uses an index that is 3% and adds a 3% margin, the fully indexed rate would be 6%. Some lenders base the amount of margin they add off your credit score. Meaning, if you have a high credit score, a lower percentage margin will be added, and you will pay less interest over the life of your loan.

ARMs have interest rate caps that place a limit on the amount your interest can increase. Usually, they come in two different forms:

  • 1. Periodic adjustment cap – This cap limits the amount your interest rate can fluctuate from one adjustment period to the next, making sure interest rates are not dramatically increasing each adjustment period.
  • 2. Lifetime cap – This cap limits how the interest rate will increase over the term of the loan. Lenders are required by law to issue a lifetime cap for ARMs.

What is the difference between a fixed-rate and an adjustable-rate mortgage (ARM)?

The difference between a fixed-rate and adjustable-rate mortgage (ARM) is that the interest rate for fixed-rate mortgages will stay the same over the life of the loan. With an ARM, the interest may increase or decrease.

People are attracted to ARMs initially because they begin with a lower interest rate than fixed-rate mortgages. This interest rate may stay the same throughout the introductory period, which usually ranges between several months and a few years. Once this period is over, your interest rate will change, and so will monthly payments.

An ARM’s interest rate is based on an index that refers to several indicators, such as the one-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). If the index goes up, so will your interest rate, and monthly payments; if the index goes down, so will your interest rate, and monthly payments.

With a fixed-rate mortgage, monthly payments and interest rates will remain consistent throughout the entire loan. This option makes it easier for borrowers to budget and manage their finances.

What are adjustable-rate mortgage rates?

Adjustable-rate mortgage (ARM) rates vary from lender to lender. Interest rates are an important factor to consider when applying for a mortgage because they heavily influence how much money a borrower will pay. Utilizing an online calculator can give you an estimate of what to expect for mortgage payments and interest every month.

What are some pros and cons of an adjustable-rate mortgage?

There are advantages and disadvantages when borrowers use an adjustable-rate mortgage. Here are some of the pros and cons:

Pros

  • Issues a lower interest rate and monthly payments during the initial period of the term. Borrowers are attracted to this mortgage because it allows them to buy larger homes for smaller monthly payments.
  • Borrowers can take advantage of lower interest rates without refinancing. They won’t have to provide funds for another set of closing costs or fees. As interest rates fall, ARM borrowers will watch their monthly payments fall as well.
  • ARM borrowers save and invest more money compared to fixed-rate mortgages. Borrowers that have lower payments can save money and earn more in a higher-yielding investment.
  • Ideal for borrowers that do not plan on living in their home for a very long time.

Cons

  • Interest rates and monthly payments can dramatically increase over the life of the loan.
  • The initial period of an ARM can be taken for granted because some annual caps do not apply during the initial change. For example, someone with a lifetime cap of 5% could see their interest rate increase from 3% to 8% in a year if the index rises.
  • Mortgage lenders have a lot of power when it comes to ARMS. They determine margins, annual caps, adjustment indexes, and among other things. So, if borrowers are uneducated on how an ARM works, they can be taken advantage of by unethical mortgage companies.

As you can see, ARMs can be great but include some factors that are out of your control. If you have any further questions about Adjustable Rate Mortgages, don’t hesitate to reach out.

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