What Is an Adjustable Rate Mortgage (ARM) Loan?

FT Contributor  | 

When you obtain a mortgage to purchase a home, you may have a choice between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). An ARM behaves just as its name implies. The interest rate isn’t static and can change according to the market. With an ARM loan, the interest rate usually starts out low and remains the same for an introductory period, then it can be adjusted. In most cases, the rate increases each year, although it does have the ability to decrease if market conditions warrant.

ARM loans may have different terms, depending on what a lender offers, but in most cases, the interest rate is usually adjusted once every year. The interest rate adjustment is based on an index, which is an analysis of market forces published by a neutral party. There are many different indexes published each year, and the lender must inform the borrower about which index it uses to determine interest rate adjustments.

Fixed-Rate vs. Adjustable Rate Mortgage

If you’re planning to purchase a home, it’s important to understand the differences between a fixed-rate mortgage and an adjustable-rate mortgage. With a fixed-rate mortgage, the interest rate remains the same throughout the duration of the loan. If you have a fixed-rate mortgage but are unhappy with the current interest rate, you can choose to refinance your loan if the market currently offers a lower rate.

Fixed-rate mortgages can make it easier to budget for long-term financial goals since the interest rate will stay the same. While your homeowner’s insurance or property taxes may fluctuate your monthly mortgage payment a little over time, you’ll generally be responsible for the same amount each month for the life of the loan. This also makes the loan more predictable and the terms easier to understand. However, fixed-rate loans are usually associated with higher interest rates, which can make an ARM loan more appealing if you’re trying to keep your initial monthly payments affordable.

Adjustable-Rate Mortgage Pros and Cons

There are various ARM options available through lenders and the terms can vary significantly. Therefore, it’s important to analyze the specific loan terms a lender is offering you before deciding if the mortgage is right for you.

Some of the most important factors to consider are if there’s an introductory period, when the rate adjusts, the interest rate cap, and its lower limit. While the terms on ARM loans may be different, there are pros and cons of these loans that are fairly consistent, no matter the specific loan terms.

Pros

In most cases, an ARM can be an appealing loan option because:

  • The initial interest rate offered is usually lower than a fixed-rate mortgage.
  • With lower initial payments, you may be able to qualify for a higher loan amount.
  • There’s no need to refinance if interest rates change in the market.
  • It can save you money if you plan to sell your home soon.
  • It allows you to put your money in other investments if the rate stays low.

Cons

There are drawbacks to obtaining an adjustable-rate mortgage, some of which you may not realize until years into your loan term. Some of the cons you should watch out for with ARM loans include:

  • Your rate and monthly payment can rise exponentially throughout the life of the loan.
  • An increased rate and payment can make it impossible to adhere to a budget.
  • Loan terms are often more complex than with a fixed-rate mortgage.
  • The lender has control over the cap, margin, and adjustment indexes.
  • Some annual caps don’t apply to the initial rate adjustment, so the first adjustment can be drastic.

Who Would Benefit From an ARM?

If you’re deciding whether to finance your new home purchase with a fixed-rate mortgage or an ARM, there are many factors to consider. If this is your first home purchase, you may want to lean toward a fixed-rate mortgage. Understanding the loan terms and the mortgage payment you’re responsible for is important, especially if you bought a home at the top of your budget.

The loan terms for fixed-rate mortgages are easier to understand, since the interest rate won’t fluctuate. Therefore, a fixed-rate mortgage can be a better choice as a first-time homebuyer because you know the monthly mortgage payment you’re responsible for won’t dramatically increase at any point during the loan’s duration.

A fixed-rate mortgage may be a better choice over an adjustable-rate mortgage if current interest rates are already low. If the current market dictates a low-interest rate, there may not be much difference between the initial interest rate offered with an ARM and the fixed-rate mortgage interest rate. In this case, it may be a smarter long-term financial decision to lock in the current low rate with a fixed-rate loan. An ARM comes with unpredictability and if interest rates in the market begin to climb, your adjustable-rate mortgage monthly payments will also increase.

You should consider an adjustable-rate loan if you’re not planning to own the home long-term. Since most ARMs offer an introductory term with a fixed interest rate, you can take advantage of these low payments, then sell the home before the interest rate increases. Before deciding on an ARM loan, consider how long you plan to stay in the home and how market conditions may affect your ability to sell. Also, make sure you understand the loan terms and the maximum monthly mortgage payments you could be responsible for at any time during the loan’s duration, just in case you don’t end up selling the home.


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