An adjustable-rate mortgage, or ARM, is a loan with a low-interest rate for the first three to 10 years, after which the interest rate is adjusted upward. This type of loan is in contrast to a fixed-rate mortgage, where the interest rate remains constant throughout the loan period. Fixed-rate mortgages are usually for a 30-year term, but the term can be as low as 15 or 20 years.
ARM Interest Rate
Adjustable-rate mortgages are unique because the loan’s interest rate will adjust according to market interest rates. As a result, payment amounts will also fluctuate in direct correlation to the interest rate. If interest rates increase, so does the monthly payment, and vice versa. Payments are calculated by taking one of the many market indices and combining it with a set ARM margin to determine the current rate.
Pros of an Adjustable-Rate Mortgage
An ARM has the advantage over a traditional loan in that, in the beginning, it offers a lower interest rate, leading to lower payments in that first, short, fixed term. Often, you’ll end up paying more over time as the interest rate rises, eventually surpassing the initial rate on the traditional loan. Still, the early lower payments may be worth the cost. An ARM can be especially tempting if you’re pushing the limits of affordability, as it starts with more reasonable payments. However, this can be risky.
If you happen to start your ARM when rates are abnormally high, you’ll get the benefit of an initial discount over traditional rates. Then, if the rates fall after your initial period, your payment will drop even further. Another advantage of this type of mortgage is that if you intend only to hold the property for a short time, shorter than the initial term on the ARM you selected, you’ll save money on interest.
Cons of an Adjustable-Rate Mortgage
The biggest downside to an ARM is that rates will likely increase, and you’ll pay more each month after your initial term. The good news is that most ARMs will have a cap on both how much they can go up per reset and how much they can go up overall. Another disadvantage of this type of mortgage is that if you plan to live in your home for a long time, longer than your initial mortgage term, an ARM isn’t the best choice.
If you’re not careful, an ARM can get you into trouble because the interest rate and terms may be more favorable with lower monthly payments than similar-sized mortgages. This can make it more difficult to get approval for another mortgage in the future. Additionally, you must pass a credit check to refinance after your initial term. If your credit score has dropped since your initial loan, you may be trapped in the initial loan with no way to refinance.
How To Manage an Adjustable-Rate Mortgage
To mitigate the downsides of going with an ARM, you must pick the one that’s right for you. Ensure there are restrictions and caps on how much the rate and payment can adjust at every reset period. These caps and regulations can be on the interest rate or the monthly payment amount.
Also, ARMs are typically listed as the years before the first adjustment and the years between subsequent adjustments. For example, 5/1 ARM means that the initial rate is good for five years and will be re-evaluated yearly. There are many different types of ARMs, but the most common are the 10/1, 7/1, 5/1, and one-year ARMs. With a one-year ARM, the initial rate is only good for a year and will adjust each subsequent year.
Types of Caps
We have alluded to the different types of caps above, such as lifetime and periodic caps. The lifetime cap will limit the maximum amount that your rate can vary from the original rate over the entire course of the loan. In contrast, the periodic cap determines the maximum change per reset period, usually annually. However, you must understand that any rate increase over and above the cap may carry over to the next period.
For example, let’s say that the rates went up 2%, but you have a 1.5% periodic cap on your ARM. If the rates stay flat over the next year, your rate might still go up the 0.5% you were behind from the previous year.
Another thing to understand is that the caps sometimes differ for every reset period and can fluctuate. After the initial term, the first increase may be capped at 3%, with the following adjustments capped at 1.5%. Ensure you understand the caps for the duration of your loan, as this can cause a wild fluctuation in your monthly mortgage payment.
Potential Snags of Caps
Overall, caps and restrictions are beneficial and work to protect you. Be careful, though, as they can be problematic in certain situations. For example, you might have a cap limiting your monthly payment amount but not the rate. If the rates go high enough and your monthly payment hits the maximum but the rates still go up, you may be making a payment that doesn’t even cover the interest for the month.
This puts you into a negative amortization in which you’re not only not decreasing the principal, but you’re actually adding to it because the excess interest that exceeds the amount of your payment will get tacked on to the principal balance.
When you’re ready to get started, reach out to the team at Titan Funding. Our experts can discuss ARM loan options, answer any questions, and help you decide if this type of mortgage loan is best for your situation. We can also discuss other investment options available through Titan Funding to determine the best action.
Call our Titan Funding team Monday through Friday from 9 a.m. to 6 p.m. at 855-928-0737, or complete our secure online form, 24 hours a day, seven days a week. We’re conveniently located at 2701 NW Boca Raton Blvd., Suite 105, in Boca Raton, Florida.
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