What Is An Adjustable-Rate Mortgage?

• An adjustable-rate mortgage (ARM) is a loan that has an interest rate that can rise or fall over time.
• It is different from a fixed-rate mortgage, which has an interest rate that never changes.
• What does that mean in real-world terms? It means that with an adjustable-rate mortgage, your monthly mortgage payment can change, which could put an unexpected strain on your finances.

Advantages of an ARM mortgage

With all of the uncertainty surrounding an ARM mortgage, you might wonder why anyone would want one. However, there can be benefits to variable-rate mortgages.

When you are shopping for mortgages and you compare rates on ARM loans to fixed-rate mortgages, ARM loans generally have lower interest rates during the initial period of the loan. So the ARM loan will have a lower monthly mortgage payment, and the difference may even allow you to qualify for a higher loan amount or a more expensive house.

Another benefit of adjustable-rate mortgages is that not only can your rate go up, it can also go down. This was the case for many borrowers who took out ARM loans before interest rates plummeted in the aftermath of the housing crash. When interest rates fall, you’ll save money on interest with a variable-rate mortgage.

However, while it’s likely you will start off paying less in interest for an adjustable-rate mortgage, you may end up paying more down the road. Adjustable-rate mortgages will typically stay fixed for a set period of time, such as three or five years. Once the initial period is over, you have no control over whether the rate rises, falls or stays the same.

Another downside is the fact that adjustable-rate mortgages can wreak havoc with your financial planning. Since you don’t know what the rate will be down the road, the amount you’ll pay for your mortgage long-term is unpredictable.

ARM rates are unpredictable

When you first get an adjustable-rate mortgage, you don’t have to worry immediately about rising rates. Instead, you get a period of time to enjoy a fixed rate before the ARM adjusts and the rate changes. Three, five, seven and 10-year terms are all common periods of time for an ARM mortgage to stay at the initial, fixed rate. A 5/1 ARM is an adjustable-rate mortgage that has a five-year fixed rate period, as indicated by the first number. After that, the rate can change every year, as indicated by the second number.

So how does a lender determine whether your interest rate will rise or fall? ARM rates typically follow the fate of an index, which is a benchmark interest rate that is indicative of general conditions in the market. Commonly used indexes for ARM loans include government Treasury notes, the London Interbank Offered Rate (LIBOR), and the Prime Rate.

Your lender will let you know which index your rate is tied to. The interest on your loan will be whatever the index rate is, plus a margin added by the lender. For example, if your margin is three percentage points and the index has a rate of 1.5%, then your interest rate would be 4.5%. If the index rate rises to 1.75% then your ARM interest rate would rise to 4.75%.

How high can my ARM loan rate go?

While your adjustable-rate mortgage’s interest rate can rise, there is some good news: there are some limitations, or caps, to how fast and high it can increase.

• Periodic rate caps keep the rate from rising beyond a predetermined point from year to year.
• Lifetime rate caps put a lid on how high the rate can rise over the entire loan period.
• Payment caps put limits on how high your monthly mortgage payment can rise over the life of the loan.

However, keep in mind that some ARMs also have limits on how low your interest rate can go, as well.

Choose your mortgage carefully

So should you get an adjustable-rate mortgage? If you’re not planning to stay in the house for 30 years and you think you will sell it before the mortgage adjusts, it might be a great option that can save you money over a fixed-rate mortgage.

You may also be able to refinance your loan before it adjusts, but you have no way of knowing today what fixed rates will be when you refinance at a later date. Refinancing may also be difficult at a later time if your house declines in value or if your financial situation changes and you can’t get approved for a loan.

Only you can determine whether an adjustable-rate mortgage is for you. Before choosing an ARM loan, find out when and how often the rate may change, as well as if there are any caps. Then, ask yourself if you could afford to pay the mortgage if the rate reached its peak. If you can’t afford that payment, an adjustable-rate mortgage may not be a risk that you want to take.

If you’re seriously considering an ARM loan, check out these tips from the Consumer Financial Protection Bureau on what to look for in the fine print.

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