Unless you’re paying for your home in cash, you will need to take out some sort of mortgage with a financial institution. Most buyers will opt for the fixed-rate mortgage. It makes sense and not even an expert will question the validity of this type of mortgage. Most people don’t know there are also viable options that make sense and might even be a better option.
An Adjustable Rate Mortgage is a financial tool that most experienced buyers would avoid at all costs. Maybe though it deserves some attention. They certainly have their place in the marketplace and can save buyers plenty of money.
To be clear, an adjustable-rate mortgage is not a subprime loan. These latter types of loans were given out to individuals with lackluster credit, no income verification, and were frankly shaky loans, to begin with.
An Adjustable Rate Mortgage Defined
Don’t we all know how a fixed-rate mortgage functions? You and your lender settle on an interest rate. The loan might be 15 or 30 years, but one thing that won’t change is your mortgage interest rate which directly affects your monthly payment.
Think of an adjustable-rate mortgage that has an interest rate that can and will move during the lifetime of the loan. What most people don’t get is that an interest rate can move up and down.
If you took an ARM loan in the last 10 years, you are probably making out well. Remember the only reason ever to consider an ARM is that it always has a lower initial interest rate than its fixed brethren
Ingredients of an ARM
- Every adjustable-rate mortgage has a teaser rate. This is the intro period where the buyer gets a low rate. It could be as little as 1 year, or it could be 5 years, 7years, or even longer. The shorter the intro period, the lower the rate.
- All ARM’s will have a series of adjustments. After the intro period has expired, you will experience your first adjustment. The type of ARM you choose will determine when and how many adjustments you will experience. Remember rates can go up or down.
- Think of CAPS as a ceiling on rates. This will limit how much your rate can go up. CAPS can limit how much your rate can go up for each subsequent adjustment and over the life of the loan.
- All ARM’s will be tied to a benchmark. This benchmark will determine if your rate goes up, down, or doesn’t change. Your loan paperwork will define the benchmark you will need to watch that will determine what happens during the adjustment periods.
Popular Types of ARM’s
Remember adjustable-rate mortgages will have an initial teaser period which is also fixed. The rate can’t change. Normally these are 3, 5, or 7 years. After this initial period has ended, then the next phase will be the adjustment periods.
3/1 ARM: The teaser period is 3 years or 36 months. Then the adjustment phase begins. Your mortgage will then adjust annually until it is paid off or home is sold.
5/1 ARM: 5 years gives you more breathing room before the adjustments come. With 60 months of fixed payments, you have even more time. You might even decide to sell your condo and move before the period is up.
3/3 ARM: 3 years of fixed payments is then followed by an adjustment. This new rate will be your new one for the next 3 years followed by adjustments that occur every 36 months.
2 Step Mortgage: In this type of ARM, there is just one adjustment. You might have an intro period of 10 years followed by an adjustment that lasts for the remainder of the mortgage.
Who Should Consider an ARM
An adjustable-rate mortgage certainly has its place. If you’re one of the following, then it can be a strong viable option.
- You’re only living here for a short time: Suppose you know for a fact that your employer will be moving you to a different part of the country within 5 years. Or maybe you never stay in one place too long. If you enter into an ARM mortgage for 3-5 years you could sell your home before the rate would ever be able to reset. Or if it did reset, the increase might not be big enough to impact your payment before you could potentially sell your place.
- Maybe you’re living in a home in a neighborhood just for the school district. When your kids graduate and move onto college, or you no longer require schools, you will move. This might be a perfect scenario for an adjustable-rate mortgage.
- You will be making more money in the future: If you know your incoming will be increasing in the future, your future earnings could offset any increase that might be coming your way. Remember some adjustable-rate mortgages may not reset for a while giving you time.
Who Should Steer Clear
- People on a fixed income: Anybody on a fixed income should avoid all ARM’s. If the interest rate were to adjust upwards significantly the owners would be hard-pressed, especially if they can’t earn more. This could lead to a forced sale or worse, a foreclosure.
- Long Term Home-owners: Buyers who know more likely than not that will be in the home for a significant amount of time. Although some ARM’s can be 7 years or longer, you wouldn’t want the uncertainty. Taking out a fixed mortgage would make the most sense here. Taking out a fixed mortgage would make the most sense here. Check out this article from Lowermybills.com to learn when you should lock in your mortgage rate for fixed rates until you are comfortable with higher rates.
- You don’t want to worry about your payments going up. If that’s you, then you know who you are
Bottom Line
- Adjustable-rate mortgages are initially always a lower-cost alternative to a fixed-rate mortgage. This is the only reason ever to agree to choose one.
- No one on a fixed income should ever consider an ARM
- There are a series of caps built in to prevent interest rates from spiking and super high payments
- For savvy buyers, a ARM can save you a significant amount of money.