If you’ve been shopping for a home, you’ve probably already realized that there is a dizzying array of mortgage products available to home buyers, each suited to a different financial circumstance. While the 30-year fixed-rate mortgage is an industry standard (and what many think of when they think of mortgages), there are actually a wide variety of viable financing alternatives, including no money down homes and the Adjustable Rate Mortgage (also known as an ARM). In this “All About” article, we’ll cover the basics of ARMs, their benefits and drawbacks, and whether or not this type of mortgage may be right for you.
What is an ARM?
ARMs—Adjustable Rate Mortgages—differ from traditional fixed-rate mortgages in that the interest rate associated with the loan changes (adjusts) over the life of the loan. There are many variations of ARMs, including “option ARMs,” which allow borrowers to choose from a pre-determined set of payment options (such as interest-only payments, set minimum payments, etc.).
How often does the interest rate on an ARM adjust?
The adjustment periods on ARMs differ depending upon which mortgage product you choose to use. However, most ARMs typically have a fixed-rate period of a few years, after which the interest rate is regularly adjusted to reflect current interest rates. The length of the fixed-rate period and the frequency of readjustment is made clear in the ARM naming convention. For example, a 5/1 ARM has an initial fixed-rate period of five years, after which the mortgage’s interest rate adjusts every year; similarly, a 3/1 ARM holds a fixed rate for three years, and is then adjusted yearly.
What are the drawbacks of Adjustable Rate Mortgages?
The biggest drawback to ARMs is that they leave borrowers open to rises in interest rates. This means that as interest rates rise, the interest rates on an ARM not in its fixed-rate period will be reset to a higher interest rate, which translates directly into larger monthly mortgage payments. However, the amount by which the interest rates on a loan can be adjusted are often limited each adjustment period by what is known as a “cap.” If the cap on an ARM were set at two percent, for example, the annual adjustment on an ARM currently at 2 percent could not go higher than 4 percent, even if current interest rates for borrowing were around 6 percent. It would not be until the next adjustment period that the interest rate on the loan could be adjusted upward to 6 percent.
Who can benefit from an ARM?
Given current low interest rates, ARMs are the perfect mortgage vehicle for buyers who anticipate staying in their homes for less than five years. The ultra-low interest rates on the fixed-period of the ARM (often up to 1 percent lower than 30-year fixed rates) can save these buyers substantial sums of money over their five years of ownership. Buyers will difficulty qualifying for higher 30-year fixed rates may also benefit from ARM financing, particularly as long as historically-low interest rates continue to be the norm.
ARMs can be complicated to understand, but they are a vital part of the suite of mortgage products offered by most lenders. If you have more questions about ARMs, or just want to find out what sort of mortgage instrument might be right for you, feel free to stop by one of LGI’s new home communities, where we can put you in touch with one of our preferred lenders.