mortgage applicationA fixed-rate mortgage is the most popular option for buying or refinancing a home, but it’s not the only option. While a fixed-rate loan provides the predictability and security of a mortgage payment that never changes, an adjustable-rate mortgage (ARM) may be a more appealing solution for some people and situations. This is especially true since many homeowners sell their homes, refinance their loans or pay off their mortgages long before the typical 30-year fixed-rate mortgage ends. Here’s what you need to know about ARMs and how to decide if they’re right for your home financing needs.


What are ARMs?

As their name suggests, ARMs are mortgages with interest rates that can change over the life of the loans. Unlike with a fixed-rate loan, it’s possible for the interest rate and monthly payment to increase after the first several years of an ARM. In exchange for this tradeoff, ARMs offer potential savings, particularly during the early years of the loans.

ARMs have separate periods of fixed and adjusting rates. They begin with a fixed-rate for several years (the introductory rate), and then the rate adjusts (the adjusting rate) once each year for the remainder of the loan. ARMs typically have intro rates that last 5, 7 or 10 years before each yearly adjustment, and they are named accordingly (e.g. 5/1 ARM, 7/1 ARM, etc.).

With an ARM, how much your rate and your monthly payment changes after each adjustment depends on the rules of the loan. Typically, your adjusting rate will be based on an economic index and will be limited by rate caps. Rate caps include the following:

  • Initial cap: how much the rate can increase on the first adjustment year
  • Periodic cap: how much the rate can increase on each following year
  • Lifetime cap: how much the rate can increase in total from the initial rate

For example, the adjusting rate on an ARM with caps of 2/2/5 could not increase by more than 2% on the first adjusting year, 2% on each year thereafter and 5% total from the initial rate.


The advantages of ARMs

The primary advantage of an ARM is that the intro rate is often lower than the rate of a comparable fixed-rate loan. When this is true, the ARM is guaranteed to provide lower monthly payments over the introductory rate period. This is particularly appealing for those who plan to sell their home, refinance their loan or pay off their mortgage before the introductory period is up.

Here’s an example of how a 7/1 ARM might compare against two fixed-rate loans over the first seven years after purchasing a $250,000 single-family home with a 20% down payment:

30-Year Fixed-Rate Mortgage 15-Year Fixed-Rate Mortgage 7/1 ARM
Interest Rate 4.625% 4.250% 4.250%
APR (annual percentage rate) 4.769% 4.499% 4.682%
Monthly Principal and Interest Payment $1,028.28 $1,504.56 $983.88

 

In this example, the monthly payment for the ARM is about $44 month less than the 30-year fixed-rate loan. Over the first seven years, this would total a savings of approximately $3,696. In different situations, as with different loan amounts or in different interest rate environments, the potential savings could be higher or lower.

The second notable advantage of an ARM is that it may be possible for the interest rate and monthly payment amount to drop during the future adjustment periods. Any drop will depend on the change in the index the ARM is tied to and may be subject to a rate “floor”. With a fixed-rate loan, the only way to obtain a lower rate is to refinance the loan, which can come with closing costs of several thousand dollars.

Important considerations with ARMs

The major consideration with any ARM is the possibility that your monthly payment could increase during the adjusting-rate period. While this total potential increase is capped, it may still be more than some people can afford. Before providing you with an ARM, lenders are required to show you the maximum dollar amount that the monthly payments could reach. If you are unable to afford this figure, an affordable fixed-rate loan is likely a safer option for you.

While getting out of an ARM before the adjusting-rate period begins is a strategy many borrowers follow, this option is not always available. Situations can change over the course of your loan, and you may end up staying in your home longer than you planned, or your loan qualifications may change.

Conclusion

While a fixed-rate mortgage is the most appealing choice for many home buyers and owners, the potential benefits of an ARM are worth the tradeoffs for some borrowers. Here are some situations that may make an ARM appealing for you.

  • ARM intro rates are substantially lower than comparable fixed-rate options
  • You plan to keep your home or mortgage for much less than 30 years
  • Interest rates are expected to drop in the coming years
  • You are willing to tolerate some extra risk with your mortgage payments

At Draper and Kramer Mortgage, we’re happy to show you your current mortgage options and advise you on which solution is right for you. If you’re considering purchasing a home or refinancing a current mortgage, please contact us anytime for a free mortgage consultation.

  • By: Draper and Kramer Mortgage Corp.
  • In: Mortgage
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