What is an (ARM)?
Purchasing a home is an exciting milestone, but before you settle into your dream property, it’s crucial to choose a mortgage that aligns with your financial goals. One potential option is an adjustable-rate mortgage (ARM). But what exactly is an ARM, and how can it benefit future homeowners?
What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage, also referred to as a variable-rate or hybrid ARM, is a loan with an interest rate that changes over time based on market conditions. ARMs typically offer a lower initial rate than fixed-rate mortgages, making them an attractive option for those seeking the lowest starting payments.
However, the initial rate won’t last indefinitely. Once the fixed period ends, your payments can vary, which may introduce unpredictability into your budget.
ARM vs. Fixed-Rate Mortgages: What’s the Difference?
Homebuyers generally have the choice between an ARM and a fixed-rate mortgage. ARMs typically start with lower payments because of the initial fixed period. But once that ends, payments may fluctuate with the market, potentially leading to higher costs. On the other hand, fixed-rate mortgages offer more stability since the rate—and monthly payments—stay the same throughout the loan term.
How Does an Adjustable-Rate Mortgage Work?
ARMs feature two phases: a fixed-rate period and an adjustable period. During the fixed period—usually lasting 5, 7, or 10 years—your rate won’t change. Afterward, your rate adjusts periodically based on a market index, influencing your payment amounts. For example, a 5/1 ARM has a fixed rate for the first 5 years, after which the rate can adjust annually for the remaining term.
Factors Affecting ARM Rates
Several factors, including the current benchmark rate and your lender’s margin, impact ARM rates. Your credit score also plays a significant role in determining the margin added to the benchmark rate.
Fortunately, ARMs typically come with rate caps, which limit how much your interest rate can increase during each adjustment period or over the life of the loan.
Understanding Rate Caps
Rate caps protect borrowers from dramatic increases. A typical ARM might have a cap structure like 2/2/5, meaning the rate can’t increase by more than 2% during the initial adjustment or subsequent periods, and it can never rise more than 5% over the life of the loan.
Conforming vs. Non-Conforming ARMs
ARMs can be categorized as conforming or non-conforming. Conforming loans meet the guidelines set by Fannie Mae and Freddie Mac, allowing them to be sold on the secondary mortgage market. Non-conforming loans, such as jumbo loans, don’t meet these guidelines and often come with different terms and conditions.
Refinancing an ARM
If your financial situation changes, you can always refinance your ARM into a fixed-rate mortgage for greater stability. The process is similar to securing your original mortgage, requiring a new loan to replace the old one. Get with your Mortgage Advisor, Dustin Dumestre (Brokered Loan Officer) to go over your options.
ARM Loan Types
ARM loans come in various structures, including 5/1, 7/1, and 10/1 ARMs. Each offers a fixed interest rate for the first several years before switching to periodic adjustments.
Advantages of an ARM
ARMs can be a smart choice for those planning to sell their home or refinance before the adjustable period begins. The lower initial rate can help you save or pay off your principal more quickly during the introductory years.
Disadvantages of an ARM
The primary risk with ARMs is that interest rates—and therefore your payments—can rise significantly once the adjustment period begins. This uncertainty can make it difficult to budget for the long term.
Who Should Consider an ARM?
ARMs are typically best suited for homebuyers who don’t plan to stay in their homes long-term or who want to take advantage of low initial payments. If you’re buying a starter home or relocating frequently, an ARM could save you money in the early years of homeownership.
Qualifying for an ARM Loan
The qualification process for an ARM is similar to that of a fixed-rate mortgage. Requirements typically include proof of income, a credit score of 620 or higher for conventional loans, and a down payment of at least 3%.
Choosing between an adjustable-rate and a fixed-rate mortgage is a major decision when buying a home. Be sure to consider your financial situation and future plans carefully to determine which loan type best fits your needs.