Understanding Adjustable-Rate Mortgages (ARMs)
An adjustable-rate mortgage (ARM) is a type of home loan that features a variable interest rate. Initially, the interest rate remains fixed for a period, after which it adjusts periodically based on market conditions.
ARMS, also known as variable-rate or floating mortgages, have their interest rates reset based on a designated index and an ARM margin. The switch from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) in 2020 aimed to enhance market liquidity.
Understanding Adjustable-Rate Mortgages (ARMs)
Mortgages provide funding for property purchases, with repayment extending over a set term along with additional compensation for lenders. Fixed-rate mortgages maintain the same interest rate, offering consistent payments, while ARMs adjust based on market trends.
ARMs consist of fixed and adjusted periods, with the initial fixed rate spanning from five to ten years, known as the intro rate. Once this period elapses, the rate adjusts based on market benchmarks.
ARMs can be conforming or nonconforming, with conforming loans meeting GSE standards and nonconforming loans failing to do so.
ARMs have rate caps limiting the maximum interest rate, influenced by credit score. They offer initial lower borrowing costs, but subsequent rates may rise or fall depending on economic conditions.
Types of ARMs
ARMs come in various forms: Hybrid, Interest-Only (IO), and Payment Option.
Hybrid ARM
Hybrid ARMs blend fixed and adjustable rates, with a set fixed-rate period followed by adjustments.
Interest-Only (IO) ARMs allow paying only interest for a specific period, leading to higher payments after this phase.
Payment-Option ARM
Payment-Option ARMs offer multiple payment alternatives, including principal and interest, interest-only, or minimum payments.
Advantages and Disadvantages of ARMs
ARMs provide benefits like lower initial rates, financial flexibility, and potential savings, but involve risks such as changing interest rates and complexities in loan terms.
Advantages
- Saves you money
- Ideal for short-term borrowing
- Lets you put money aside for other goals
- No need to refinance
Disadvantages
- Payments may increase due to rate hikes
- Not as predictable as fixed-rate mortgages
- Complicated
How the Variable Rate on ARMs Is Determined
Post the fixed-rate period, ARM interest rates fluctuate based on a reference rate (ARM index) and the ARM margin, comprising a fixed lender added interest.
Adjustable-Rate Mortgage vs. Fixed-Interest Mortgage
Unlike ARMs, fixed-rate mortgages maintain a steady interest rate throughout the loan term, providing stability but potentially at higher rates compared to ARMs. Fixed-rate loans offer consistent monthly payments without uncertainty.
Is an ARM Right for You?
ARMs suit borrowers anticipating short-term loans, expecting income growth, or planning early loan repayment. Rate caps on ARMs limit potential rate hikes, though caution is advised to avoid negative amortization.
Adjustable-rate mortgages may not be suitable for everyone due to fluctuating payments and the potential risks associated with interest rate spikes, especially without rate caps.
The Bottom Line
Borrowers have the option to choose between fixed-rate and adjustable-rate mortgages based on their financial goals and risk tolerance. Exploring the pros and cons of ARMs can help borrowers make informed decisions, especially those planning for short-term property ownership or early mortgage payoff. Consulting with a financial expert can provide further clarity on the best mortgage choice.