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 that 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 1-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 1-year Constant Maturity Treasury 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 adjustments and the total increase limit for the life of the loan.
If you’re shopping around, it’ll 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 consider.
What’s The Interest Rate Environment?
It can make more sense to get an ARM when interest rates are on the rise. The reason for this is when interest rates are on the rise, there tends to be a more pronounced difference between fixed and adjustable rates. The rate during the initial fixed period for an ARM loan will be lower compared to a fixed rate at this time than it would be if fixed rates were lower.
Economists take a look at the difference between the rates on a graph known as a yield curve. The higher rates are rising, the bigger the difference between fixed and adjustable rates. When rates are lower, there tends to be less difference, and it becomes a shallow yield curve.
When fixed interest rates are rising, it could make a lot of sense to look at an ARM.
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’re able to pay off your loan entirely during the fixed low-rate period of an ARM, you’ll 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 5 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 Rocket HQSM tool can help. With Rocket HQSM, 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 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.
For both first-time home buyers and savvy refinancers, 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) 769-6133.