Homeownership is a classic part of the American Dream. When you own a house, you become free to create your own space and make any changes you want. It’s a much more freeing experience than renting a place to live.
But, before you can own a house, you have to pay for one. That’s where your mortgage comes in.
When you apply for a home loan, you receive home loan options. The first is a fixed-rate loan, which has a fixed interest rate. The other is an adjustable-rate mortgage.
You may wonder, what is an adjustable-rate mortgage? After all, this is a less common option than the standard fixed-rate home loan.
If you’re wondering about these types of home loans, keep reading! We’ll tell you everything you need to know about adjustable-rate mortgages below. So, without further ado, let’s jump right in!
What Is an Adjustable Rate Mortgage?
An adjustable-rate mortgage (ARMs) is a home loan with an interest rate that adjusts based on market changes. ARMs often start with a lower interest rate than the average fixed-rate mortgage. So, these are popular options for borrowers looking for the most affordable rate available.
Unfortunately, this lower interest rate won’t stick around forever. Once the initial lending period ends, your monthly payments will begin to fluctuate. These fluctuations can make it more challenging to factor your payments into your budget.
But, there are steps you can take to stay prepared. This way, even when your rates increase, you remain prepared.
How Do Adjustable-Rate Mortgages Work?
Different ARMs offer varying lengths of time for your introductory rate’s duration. For example, the most popular ARM is the 5/1 adjustable-rate mortgage.
This home loan allows you to pay the introductory rate for five years. When that five-year period ends, the interest rate begins to vary each year.
There are other options for these loans as well. Some lenders offer:
- 3/1 ARMs
- 7/1 ARMs
- 10/1 ARMs
The front number is the number of years you can continue paying the introductory loan. The back number refers to the annual changes in your rates. You can learn more about this on modernloans.com.
Adjustable-Rate Mortgage Caps
You may wonder, “How much will my rates fluctuate? Will they ever reach impossible highs?”
The answer to this question, thankfully, is no. ARMs come with caps that limit how much your rates and payments can change. Otherwise, you could potentially face bankruptcy payments.
There are three types of limits for your loan:
- Periodic rate caps
- Lifetime rate caps
- Payment caps
Periodic rate caps limit how much interest your lender can charge each year. In contrast, lifetime rate caps limit how much your interest can rise over the loan’s lifespan.
Finally, there’s the payment cap. This cap limits how much your monthly payment can rise over the loan’s life in dollars. This provides a set limit in currency rather than in percentages.
The Different Types of ARMs
You may be surprised to learn that most of what we’ve discussed so far applies to one type of adjustable-rate mortgage. But, there are three types of ARMs available to borrowers. Once you know about these three, you can determine which is the best option for your budget.
Hybrid Adjustable-Rate Mortgages
This type of ARM is the traditional model. The loan starts with an affordable fixed-interest rate for a set number of years.
Usually, these loans last for five years. But, they could last anywhere from 3-10 years.
Once this period runs out, your interest rate adjusts up or down on a determined schedule. This fluctuation occurs once annually.
Interest-Only Adjustable-Rate Mortgage
Interest-only ARMs require the borrower to pay interest exclusively for a set period. During this time, the borrower will not pay the principal.
Once that period ends, you’ll become responsible for paying both the interest and principal. Sometimes, the interest-only period lasts a few months. In other situations, it could last for years.
Finally, the borrower won’t build any equity for the duration of this period unless the house appreciates in value. You can learn more about this here.
Payment-option ARM
In this structure, borrowers can choose their own payment plan and schedule. This model gives the borrower significant freedom. They can use this structure to choose an interest-only plan and the number of years for this period to last.
Borrowers can also choose a payment equal to or higher than the required minimum. But, sometimes, this freedom comes back to bite you. These plans sometimes result in negative amortization.
In short, this means that your loan balance increases because you don’t pay enough to cover the interest. If the balance becomes too high, your lender may require you to pay much heavier payments.
How Lenders Determine the Variable Rates on ARMs
Most ARM rates come from one of the three following indexes:
- Weekly constant maturity yield on one-year Treasury bill
- 11th District Cost of Funds Index (COFI)
- The Secured Overnight Financing Rate (SOFR)
The treasury bill determines your rates based on the yield debt securities issued by the US Treasury. The Federal Reserve Board tracks these securities to ensure their value.
The COFI rate depends on the interest that financial institutions pay on deposits. Finally, the SOFR is the benchmark rate for ARMs. Formerly, this position belonged to the London Interbank Offered Rate.
How will you know which index determines your ARM interest rate? You can find this information on your loan paperwork.
When lenders set their ARM rates, they choose an index rate and add a set number of percentage points. These points constitute the “margin.” Throughout your loan’s lifespan, the margin will not change.
Find the Best ARM for Your Budget
If you were wondering, “What is an adjustable-rate mortgage” we hope you’ve found an answer! These types of home loans can be an excellent resource for new homeowners looking for affordable interest rates.
So, consult with a financial expert to decide on the best ARM for your budget. Before long, you’ll be able to purchase the home of your dreams!
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