Buying a house is one of the most significant investments you’ll make in your lifetime. If you’re planning to finance your purchase with a mortgage, there are two main types of loans to choose from: fixed-rate mortgages and adjustable-rate mortgages (ARMs). In this article, we’ll discuss everything you need to know about adjustable-rate mortgages so that you can make an informed decision when choosing a mortgage.
What is an adjustable-rate mortgage (ARM)?
An adjustable-rate mortgage (ARM) is a type of mortgage that has an interest rate that can change periodically over the life of the loan. This is different from a fixed-rate mortgage, where the interest rate stays the same throughout the entire term of the loan.
ARMs are typically structured with an initial fixed-rate period (e.g., 5, 7, or 10 years) followed by a variable-rate period where the interest rate can adjust up or down based on market conditions. This means that your monthly mortgage payments could increase or decrease, depending on how interest rates change.
How do adjustable-rate mortgages work?
Adjustable-rate mortgages have two parts: the index and the margin. The index is a benchmark interest rate that lenders use to determine the interest rate for your ARM. The most common index is the London Interbank Offered Rate (LIBOR), but other indexes such as the Prime Rate or the Constant Maturity Treasury (CMT) rate may be used.
The margin is the lender’s profit margin, which is added to the index to determine the interest rate for your ARM. For example, if the index is 2% and the margin is 2.5%, your ARM interest rate would be 4.5%.
During the fixed-rate period, your interest rate and monthly payments are fixed and will not change. After the fixed-rate period, your interest rate will adjust up or down based on changes in the index.
It’s important to note that there are caps on how much your interest rate can increase or decrease during each adjustment period and over the life of the loan. This helps protect borrowers from drastic increases in their monthly payments.
Advantages of adjustable-rate mortgages
One of the main advantages of an adjustable-rate mortgage is that they often have lower initial interest rates than fixed-rate mortgages. This means your monthly mortgage payments will be lower during the fixed-rate period, which could allow you to afford a more expensive home.
Another advantage of an ARM is that if interest rates drop, your monthly payments could decrease. This could potentially save you money on your monthly mortgage payments over time.
Disadvantages of adjustable-rate mortgages
One of the main disadvantages of an adjustable-rate mortgage is that your monthly mortgage payments could increase if interest rates rise. This could potentially make your monthly payments unaffordable, especially if you’re on a tight budget.
Another disadvantage of an ARM is that they can be more difficult to understand than fixed-rate mortgages. There are many variables to consider when choosing an ARM, such as the index, the margin, and the caps on interest rate adjustments.
Should you choose an adjustable-rate mortgage?
Whether or not an adjustable-rate mortgage is right for you depends on your financial situation and your personal preferences. If you’re on a tight budget and want a predictable monthly mortgage payment, a fixed-rate mortgage might be a better option. However, if you’re willing to take on some risk and want to potentially save money on your monthly payments, an adjustable-rate mortgage might be a good choice.
The Takeaway
In conclusion, an adjustable-rate mortgage can be a good choice for some borrowers, particularly those who are planning to stay in their home for a short period of time or who expect their income to increase over time. However, it’s important to weigh the risks and benefits carefully and to work with a trusted lender who can help you understand the terms of the loan.