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When it comes to mortgages, conventional wisdom would push you to a 30-year fixed rate. For some people, this makes a lot of sense. On the other hand, if you only plan on being in your house for a few years, it might be time to look at other options.
When you take a 30-year fixed mortgage, you’re paying extra compared to a shorter-term or adjustable rate loan in exchange for that rate security. If you don’t need that security, why pay for it? One of the options you can take a look at is a 5-year adjustable rate mortgage (ARM). It offers the lowest possible rates.
If you want to go over your options, you could talk to one of our Home Loan Experts. Read on to learn some more about how ARMs work.
Adjustable Rate Basics
The 5-year ARM is a 30-year loan, but the rate only stays fixed for the initial five-year period. When that five years is up, your rate will adjust up or down in line with current market rates. In addition to the 5-year option, you can also commonly find ARMs that have 7- or 10-year fixed terms.
If you’re still in the home at the end of the fixed period, you have a couple of options. You can refinance into a fixed-rate loan or let it adjust up or down with the market. If you do choose to stay in the loan, the interest rate adjusts once per year every year until you sell, refinance or pay off the loan.
There are caps on how much your interest rate can change when it initially adjusts as well as limits on how much it can adjust each subsequent year and over the lifetime of the loan.
Your adjustment is based on different market indexes depending on what type of loan you have. If you have a conventional loan through Fannie Mae or Freddie Mac, your rate is based on the one-year London Interbank Offered Rate (LIBOR) on the date of your adjustment. If you have an FHA or VA loan, your rate is based on the one-year Constant Maturity Treasury (CMT) rate. In either case, these rates are then added to a fixed margin to get to your actual mortgage rate.
Advantages of a 5-Year ARM
One of the advantages of an adjustable rate mortgage is the initial fixed interest rate period – the time in which the interest rate is fixed or frozen. This comes in handy if you plan to refinance or sell your home, say, in five to seven years – before the fixed period has ended – in which case an ARM is typically the best mortgage option for you.
Even if you don’t plan on moving after the first five years, your mortgage payment is significantly lower than it would be if you were making the payment on a comparable fixed loan. You can use this to your advantage by taking the money you save on your monthly payment with an adjustable rate and putting it directly toward your principal. This way, you pay down your balance faster and pay less interest over time. Even if your rate goes up, you’ll have a lower balance to pay interest on.
Putting Numbers to the Savings
What can this mean for you? Let’s check out some numbers to help put this into perspective.
If you have a conventional 30-year fixed mortgage, a typical rate right now might be 4.25%. On a $200,000 home, your estimated monthly payment would be $983.88. This doesn’t include taxes or insurance payments.
Let’s compare this to a 5-year ARM with an initial rate of 3.75% for the same loan amount. Your estimated monthly payment would be $926.23, a monthly payment savings of $57.65 over the first five years of the loan. If you choose to put the savings back toward the principal, you could pay off an extra $3,459 in principal over the fixed period and save on interest over the lifetime of the loan.
Your own payment may vary slightly due to state regulations and other factors. If you would like to try out your own numbers, check out our amortization calculator.
While the ARM is a great option for some people, it’s not for everyone. The main thing to be prepared for ARM is that after the fixed period, folks need to be ready for the fluctuations in interest rate and monthly payment, which could rise and fall with the market. If you’re unsure, a mortgage expert can help you decide if this type of loan is right for you.
Are you interested in an ARM? You can get a preapproved for a purchase or a complete refinance approval through Rocket Mortgage® by Quicken Loans®. Would you rather get started over the phone? One of our Home Loan Experts would be happy to take your call at (888) 980-6716. If you have any questions, leave them for us in the comments below.
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