Misconceptions abound when the home loan conversation turns to adjustable rate mortgages (ARMs). The truth is, many people are overlooking what could be the best loan option for a homeowner in the right situation. Conventional wisdom dictates you want the certainty of a fixed-rate loan, and it’s a very good option for a lot of people. But depending on your situation, bucking the trend could get you the best loan.
Let’s go over what ARMs actually are, how they work and who they make sense for.
Definition of an ARM Loan
As the name suggests, adjustable rate mortgages or ARMs have interest rates that adjust over time based on conditions in the market. These are mortgages with 30-year terms that have initial rates which stay fixed for a specified number of years at the beginning of the loan term before they adjust for the remainder of the loan term.
How Does an ARM Loan Work?
As mentioned above, the ARM starts with a fixed-rate period. Common fixed periods are 5, 7 or 10 years.
At the end of this initial timeframe, rates adjust up or down based on current market rates. This adjustment usually happens once per year for the remainder of the term or until you pay it off, but the timing and frequency of adjustments will be specified in your loan documentation.
When rates do adjust, they go up or down based on an index. For conventional loans, this is based on the one-year London Interbank Offered Rate (LIBOR) added to a margin to come up with your final rate.
The future of LIBOR is uncertain, but it remains the index used for conventional ARMs at this point.
FHA and VA ARMs have interest rates based on the one-year Constant Maturity Treasury (CMT) added to a margin.
Finally, while there’s no limit (beyond the actual margin) to how much an interest rate can go down, there are caps that prevent your interest rate from rising indefinitely.
These caps typically cover the maximum amount of the initial upward adjustment, as well as caps for subsequent adjustment and the total increase limit for the life of the loan.
If you’re shopping around, it will be helpful to know the way these things are typically written so you can compare options. Let’s take a look at an example:
7/1 ARM, 5/2/5
The details on this particular loan are as follows: The rate is initially fixed for 7 years, after which it adjusts up or down once per year (7/1). Your rate can go up no more than 5% on the initial adjustment, and 2% on each subsequent adjustment. Finally, in no event can your rate go up more than 5% from your initial rate for the entire lifetime of the loan (5/2/5).
ARM vs. Fixed Rate
The main difference between an ARM and a fixed-rate mortgage is the mere fact of adjustment itself. Once you close on a fixed-rate loan, the rate never changes, but after the initial fixed period on an ARM, the rate can go up or down. There’s less certainty.
On the other hand, there’s one big advantage to ARMs. Because the rate can change after the fixed period, investors don’t have to account for inflation potentially 30 years down the line. This means that the initial rate you get during the fixed-rate timeframe on the front of the ARM loan can be lower than you might get on a traditional fixed rate mortgage.
This upfront savings could work to your advantage in multiple ways that we’ll discuss below.
Is an ARM Loan Right for Me?
Now that you know what an ARM loan is, how do you know whether it’s right for you? There are several factors you’ll want to take into consideration.
Rates Are Increasing
The reality is that mortgages rates are going up. The 30-year fixed mortgage rate has gone up from an average of 3.96% at this time a year ago to 4.52% as of July 19, 2018, according to Freddie Mac.
With an adjustable rate mortgage, you can attain a low rate for a fixed period of time. Your low interest rate will stay fixed for a period of five to seven years before it adjusts up or down depending on the market at that time. So if you’re in need of a home loan, it’s a good idea to lock your rate in now!
New York homeowner Denise Panza decided on an adjustable rate mortgage for the home that she built a couple of years ago because of the initial low fixed rate that it offered. “It was well over a full percent lower than the going fixed rate, and depending on the loan size, that’s a significant savings every month,” she said.
Save During the Fixed Rate Period
Moreover, by making payments with a low rate for a fixed period, you could save a substantial amount of money, advised James Milne, Capital Markets Product Manager at Quicken Loans. If you make extra payments toward the principal during the fixed low-rate period of your ARM, your balance will go down and the more principal you pay off, the more money you save on interest in the long run. As a result, “payments will not rise dramatically when the loan re-amortizes,” Milne added.
Additionally, if you are able to pay off your loan entirely during the fixed low-rate period of an ARM, you will save a significant amount on interest in comparison with a conventional 30-year loan.
“I took out an ARM fixed for 5 years in 2004,” shared homeowner Barry Graham. “Since 2009 my rate has dropped almost every year. I am thinking of refinancing now, but I certainly have no regrets about what I did; it was certainly better than a 30-year fixed,” Graham said. “The only difference is that now rates look like they are going to increase, but in 5 years, who knows?”
Planning for a Short-Term Stay?
If you know you’re going to be moving before the rate could adjust higher than the initial rate, then an ARM could be just right for you! An adjustable rate mortgage is an excellent option for those buying a starter home who have the hope of moving into a bigger house within the next five years.
Or, if you relocate fairly frequently, committing to a 30-year fixed-rate mortgage won’t grant you the same flexibility as an adjustable rate mortgage. With an ARM, you could take advantage of the low rate today with the knowledge that you’ll be moving on before the mortgage adjusts to a different interest rate. Lower rates mean lower monthly payments, which gives you the opportunity to save up for your next place.
Improve Your Credit
Have you been consistently late with, or completely missed, paying your monthly bills? If so, your credit might need some repair. If you’re unsure of your current credit score, our QLCredit tool can help. With QLCredit, you can check your credit score and get visibility into your debt and credit, so you can understand how it influences your overall financial situation.
In order for you to eventually get the home of your dreams, you may have to purchase a more affordable home where you can easily make your payments and rebuild your credit. If that’s the case, an ARM is right for you. As long as you’re able to pay your bills on time, you can save money while also reestablishing your credit. It’s a win-win for you.
High Debt-to-Income Ratio
Do you have quite a few student loans you’re paying off? If so, there’s a possibility your debt-to-income ratio (DTI) is too high for you to prove you can afford the home you want. Your DTI is a percentage and is calculated by dividing your total minimum monthly debt payments divided by your gross monthly income.
If you have a high DTI, an ARM may be a good choice. By taking advantage of the lower interest rate and low monthly payments during the fixed period, you can put the money you’re not spending on your home toward other bills, such as your student loans. The sooner you pay off the loans, the better off you’ll be in the long run.
Whether you’re a first-time home buyer or a savvy refinancer, if interest rates continue to rise as predicted through the new year, then an ARM could make more financial sense than a fixed-rate mortgage for your home loan.
Whether you’re interested in an ARM or a fixed-rate loan, you can get started with your mortgage approval online. On the other hand, if you would rather start over the phone, one of our Home Loan Experts would be happy to speak with you at (800) 785-4788.
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