Adjustable-Rate Mortgage (ARM)
Adjustable-rate mortgages (ARMs) offer very low interest rates for a set period (typically 5, 7 or 10 years), after which the interest rate will adjust and increase. ARMs are a great option for buyers who intend to move or refinance in the near future.
Benefits of Adjustable-Rate Mortgage (ARM)
- Lower interest rates
- Down payments as low as 5%
- Payments could decrease if rates fall
- Perfect for buyers who know they will sell and move again within 5-10 years
- Minimum 5% down payment
- Minimum credit score of 620
- Flexible credit requirements
- Lower monthly payments
What is an adjustable-rate mortgage (ARM)?
An adjustable-rate mortgage (ARM) is a loan with an initial fixed-rate period and an adjustable-rate period. The interest rate does not change during the fixed period, but once the adjustable-rate period is reached, rates are subject to vary every 6 months.
In reality, ARMs are a hybrid loan product, merging a fixed upfront period with a longer adjustable period. Most of our clients look to refinance or sell their homes before the start of the adjustable period, taking advantage of the lower rate of the ARM and the stability of the fixed-rate period.
The most common ARM types are 5/6, 7/6, and 10/6 ARMs, where the first number indicates the number of years the loan is fixed, and the second number shows the frequency of the adjustment period – in most cases, the frequency is 6 months. In general, the shorter the fixed period, the better the interest rate. ARMs with a 5-year fixed-term or lower can often have stricter qualifying requirements as well.
How are ARM rates calculated?
During the fixed-rate portion of the ARM, your monthly payment will not change. Just as with a fixed-rate loan, your payment will be based on the note rate that you selected at closing.
The interest rate you will pay during the adjustable period is set by the addition of two factors – the index and the margin, which combine to make the fully indexed rate.
The index rate is a benchmark that all ARMs are based on, typically derived from the short-term cost of borrowing between banks. This rate is determined by the market and is not set by your individual lender. Most ARMs nowadays use the Secured Overnight Financing Rate (SOFR) index.
The margin is a rate set by your individual lender, usually based on the overall risk level a loan presents. This will not change over time and is determined directly by the lender/investor.
Caps are limitations set during the adjustable period. Each loan will have a set cap on how much the loan can adjust during one adjustment period (semi-annual cap) and over the life of the loan (lifetime/initial cap).
NOTE: Caps (and floors) also exist to protect the lender in the event rates drop to zero to ensure lenders are adequately compensated regardless of the rate environment.
When is the best time for an ARM?
ARMs are market-dependent. When the traditional yield curve is positive, short-term debts such as ARMs will have lower rates than long-term debts such as 30-year fixed loans. This is the normal case because longer maturity means larger risk (and thus a higher interest rate to make the risk worth it for investors). When yield curves flatten, this means there is no difference in rate from an ARM to a fixed-rate option, which means the fixed-rate option is always the right choice.
What are interest rates for ARMs?
The main appeal of an ARM is the lower interest rate compared to the security offered by fixed-rate alternatives. Depending on the financing type, the difference between an ARM and a fixed-rate loan can be anywhere from 1/8% to 1/2% on average. Jumbo loan products often have the most noticeable difference for ARM pricing, since Fannie Mae and Freddie Mac tend to incentivize the purchases of less risky loans for conforming options
View mortgage rates for March 24, 2023
Pros & Cons of Adjustable-Rate Mortgages
Lower Initial Interest Rates
Because of the risk you take on knowing your rate can change in the future, an ARM is structured so you get a lower interest rate in the first several years of the loan compared to a fixed-rate loan. These initial savings can be reinvested to pay off the loan faster or used to pay for home upgrades and expenses.
Due to the flexibility that a refinance allows, it is not hard to take advantage of the lower fixed-rate period of ARMs and then refinance into another ARM to effectively extend this fixed-rate period.
For borrowers looking to sell in the near horizon, there is no downside to taking advantage of an ARM’s lower monthly payment if it is available, given the loan will be paid off far before the adjustable period begins
Possibility of Lower Adjustable Rates
In the unlikely event that interest rates fall, you could theoretically be left with a lower monthly payment during the adjustable period if the index your loan is based upon goes to 0%. While this is a beneficial scenario, when rates fall you will often see refinance opportunities for fixed-rate loan options that may be even lower.
Subject to Market Volatility During the Adjustable Period
Since your loan will be adjustable, your monthly payment could change without any adequate preparation. Since you cannot predict the market years down the line from your home purchase, by sticking with an ARM long term you are potentially leaving your monthly payment up to chance with the adjustable-rate period.
More Complex and Harder for Financial Planning
Taking full advantage of an ARM requires financial planning to see when a refinance opportunity makes the most sense and potentially forecasting if interest rates will remain at a level you are comfortable refinancing into in the future. If this seems to be too much risk and not enough reward, the traditional fixed-rate loan may be the best option for you.
High Risk Level
If you are considering an ARM you should think to yourself, “will I be able to afford this loan if the monthly payment increases?” If you have hesitancy about this, then you may be more comfortable with a fixed-rate loan and the long-term financial security it assures.
Who should consider an ARM loan?
For clients looking to sell a home before the fixed-rate period of an ARM ends, taking the lowest possible rate during that period makes the most sense financially. Likewise, these owners would be wise to avoid paying discount points to lower their interest rate since this upfront cost of points will not be recouped if the home is sold in the short term.
Borrowers Looking To Refinance Soon
ARMs are best utilized with a future refinance, either from an ARM to another ARM to extend the fixed-rate period, or from an ARM to a fixed-rate to achieve long-term stability (especially when rates are expected to trend upwards).
View mortgage rates for
March 24, 2023
View mortgage rates for March 24, 2023
Who should consider a fixed-rate loan instead of an ARM?
Future interest rates are unpredictable, so an ARM is not desirable for those who worry about what the future market may entail. Taking out an ARM requires a comfort level with the risk that monthly payments could increase in the future.
For borrowers who are not looking to sell or refinance, locking in a rate that you are comfortable with for the life of the loan is the most appealing option. If this is going to be your forever home and you want this purchase to be a one-and-done, the fixed-rate loan is the best option for you if you are comfortable with the monthly payment.
Buyers Who Want Simplicity
The 30-year fixed-rate mortgage is the ultimate “set it and forget it” loan, which is why a vast majority of our clients choose this option. For many, the mortgage space is already crowded with too many confusing terminologies and products, and going with the secure option may be the best route to owning a home and paying a mortgage that you know will not change for the life of the loan.
Is an adjustable-rate mortgage (ARM) right for you?
The best way to determine whether an ARM makes the most sense for you is to talk to one of our mortgage experts at JVM Lending. Our experts can walk you through monthly payment scenarios, give you current interest rates, and discuss any other questions or concerns you might have.
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