If you haven’t noticed, the prices of homes have skyrocketed. And stressed buyers are searching for any way to make their dream of homeownership attainable. In this new interest rate environment, ARMs (or Adjustable-Rate Mortgages) are making a comeback.
Borrowers who choose an adjustable-rate mortgage accept the risk that their rate may change over the course of their mortgage term. That risk can reap benefits, though, since, in many scenarios, it’s possible to save up to 1.5% on your interest rate by choosing a 7-year ARM over a traditional 30-year fixed-rate loan.
What is an Adjustable-Rate Mortgage (ARM)?
As the name suggests, an adjustable-rate mortgage (ARM) is a home loan in which the interest rate fluctuates throughout the life of the loan. This contrasts with a fixed mortgage in which the rate is locked in for the entire life of the loan. ARMs will typically offer lower interest rates initially, but borrowers’ monthly payments will change after a set period of time.
Advantages of an Adjustable-Rate Mortgage
Here are some of the advantages that make ARMs worth considering.
Low initial monthly payments. ARMs offer a low monthly payment for a set time after you purchase your home. With lower payments, you’ll have more flexibility in your budget.
A good option for short-term buyers. If you buy a home but don’t intend to live in it for long, any potential future adjustments in rate may not be a problem.
Fluctuation could work in your favor. The risk you take is that interest rates may rise from the time you purchase your home. However, they also have the potential to go down and save you even more money.
Faster equity accumulation. When you have more cash on hand at the time of purchasing your home, you can benefit from the lower initial interest rate and apply the savings to the principal. This allows you to accumulate more equity at the beginning of your term.
Who Could Benefit From an ARM?
Buyers of starter homes and short-term dwellers. ARMs make sense if you know you do not plan to stay in your home for a long period of time.
Borrowers whose income will increase in the near future. Those who have the reliable expectation that their income will be better able to afford any potential increases in monthly payments. An example of this case is a medical resident who is graduating soon and planning to receive a significant pay raise.
Homebuyers purchasing a home at a time when interest rates are expected to fall. When interest rates are higher than normal and economists predict that they will decrease soon, it may be worth it to choose a variable rate instead of locking in a higher fixed rate.
Understanding Your Adjustment Period
So what does the adjustment look like with an ARM? You’ll often see ARMs expressed as two numbers: for example, a 5/1 ARM or 7/6 ARM. Every ARM has a fixed rate period and an adjustable-rate period. With a 5/1 year ARM, your interest rate will be fixed for five years, then after that 5 years, the interest rate will adjust once every year after that. Sometimes the second number indicates months instead of years as in the case of a 7/6 ARM. In that case, the rate is fixed for the first seven years and then changes every 6 months for the remainder of the term.
How Are Rates Determined?
Borrowers need to understand why rates change. There are two measurements used to calculate adjustable mortgage rates: the index and margin. The index is a base interest rate that indicates general market conditions.
The margin is set by the lender at the time you apply for your loan and will usually add a couple of percentage points to the index. The index is variable and the margin is constant. Together they make up the ARM. For example, if the index rate is 3% and the margin on your loan is 2%, your interest rate will be 5%. While the index may change over time, the margin should remain the same.
Need Help Deciding if an ARM Is the Best Choice?
If you are planning to buy a home but don’t know which type of mortgage is best, let the experienced mortgage advisors at Alderus Mortgage guide you through the process. We provide a Total Cost Analysis to help you determine which mortgage product is the best fit for you. Contact us to get started!
Here’s our co-founder, Coby Baker, with more on why an ARM might make sense for you.