Adjustable rate mortgages (ARMs) have become a popular choice for homebuyers due to their flexibility and relatively low initial interest rates. But like any mortgage product, ARMs come with some risks; so before committing to an ARM, here are some things you should take into account:
The Common Types of ARMs
A 5-, 7- or 10-year ARM is the most popular choice for homebuyers. These loans begin with a fixed interest rate for that period and adjust to either higher or lower ones when it resets. They’re also available in hybrid forms that combine the advantages of both fixed-rate and adjustable rate mortgages.
Younger buyers, who tend to be less risk averse, may prefer an ARM due to its lower introductory rates during the initial fixed rate period. This makes saving money for a down payment easier and reduces monthly payments as well.
During your initial introductory period, lenders use an index to calculate your mortgage’s fully indexed rate. This index typically takes into account the current interest rate environment in your area. Your lender then adds a margin to this index in order to arrive at an actual interest rate – what you’ll pay each month.
In addition to the fully indexed rate, each ARM includes a margin that can increase or decrease your interest rate depending on market conditions. Lenders may wait until after the introductory period ends before adding this fee, while others include it from the start.
The Common Types of ARMs With Caps
When applying for an ARM, your lender will assign you both a starting rate and margin. The margin is simply an extra percentage point added to the index to calculate your full interest rate.
This margin, which is added to the index at every adjustment period, helps protect you from paying too much interest over the life of your loan if rates rise. On average, this margin is around 2% but may differ by lender.
Annual and Semiannual Caps: These limits determine how much your interest rate can rise during each adjustment period, usually every six months or annually depending on the index. They can be as high as 2%.
Lifetime and Initial Caps: These limits protect you from paying an astronomical amount in interest over the life of your loan. Typically, they’re set at 2% and may differ between lenders; however, they tend to remain consistent across most loans.
If you’re uncertain whether an ARM is suitable for you, speak to your mortgage lender. They can answer all of your questions and assist in the decision-making process.
When making your final decision about a mortgage, whether an adjustable rate loan or fixed-rate loan, it’s essential to weigh the pros and cons of each option. You might find that having a fixed-rate mortgage makes more financial sense for you and your family in the long run.