The Realities of Adjustable-Rate Mortgages
Let’s dispel some common misconceptions about ARMs and consider when they make sense for homeowners.
Adjustable-rate mortgages, commonly known as ARMs, are often misunderstood. Let’s take a look at how they really work and when an ARM can be used to your advantage.
How an ARM works
Unlike a fixed-rate mortgage that has the same interest rate over the life of the loan, the interest rate with an ARM varies over the life of the loan.
Typically, an ARM has an initial fixed-rate period that can range from months to years. After the initial period, the interest rate can change periodically, often at six-month intervals, for the remaining life of the loan. The advantage of ARMs is that their interest rates are typically lower than those for fixed rate loans during the initial period.
Some ARMs are called hybrid loans. For example, a Consumers 10/6 ARM is a 30-year loan with a fixed interest rate for 10 years. After the loan reaches the 10-year mark, the rate will be adjusted once every six months for the next 20 years.
You might also see a 7/6 ARM or 5/6 ARM. In these cases, the initial fixed-rate period is 7 or 5 years, followed by adjustments every six months.
The change in interest rates is linked to an index, most often the prime rate. The adjustment is based on the index rate plus a previously agreed-upon margin with the lender.
Another type of ARM is the interest-only loan. An interest-only loan is structured to allow you to pay interest only for a certain period, often 3-10 years. During the interest-only period, payments are lower because the principal loan amount isn’t yet being repaid. After the interest-only period ends, payments will go up even if interest rates remain the same because principal repayment begins.
Misconception: ARM rates will only rise
Reality: Rates with an ARM can adjust up or down. It all depends on which way rates move for the index to which the ARM is set.
Misconception: ARM rates can change at any time
Reality: An ARM rate won’t change arbitrarily. The terms of the loans determine when the rate is adjusted. Typically rates are adjusted annually or semi-annually.
Misconception: ARM rates have no upper limit
Reality: ARMs have interest rate caps. The terms of the loan will either specify a periodic or lifetime cap.
A periodic cap limits how much the interest rate can go up or down from one adjustment period to the next.
A lifetime cap limits how much the interest rate can increase over the life of the loan.
When is a good time to use an ARM?
Homeowners who plan to move within the initial period of lower interest rates use ARMs to keep their monthly payments low. Common reasons for a planned move are relocation or a growing family. With the exception of interest-only ARMs, these homeowners also build home equity while keeping their monthly payments lower than a fixed-rate loan.
Another reason people use ARMs is that they’re confident their financial resources will increase by the time rates are adjusted. There could be a promotion or inheritance on the horizon that would allow them to make higher payments or pay off the loan.
To find out if an ARM is right for you, check out our home mortgage page or talk to one of our mortgage loan officers at 800-991-2221.
Consumers helps more than 2,000 members finance land, first and second homes, and home improvement projects each year. We’d love to help you with a mortgage or home equity line of credit; contact us online or call us at 800-991-2221.