In the past, mortgages meant a very specific type of loan, and almost everybody used the same mortgage program. But today, there are dozens of different mortgage options, helping to meet the needs of today’s borrowers.
An adjustable-rate mortgage is one of those options. And unfortunately, most people don’t understand what these loans are, so they skip over them without any consideration.
But what is an adjustable-rate mortgage, and how might it be the financial help you are looking for? Keep reading below to learn about this unique program and to see if it’s right for your situation.
Adjustable-Rate Mortgage Definition
An adjustable-rate mortgage (ARM) accomplishes the same goals as traditional mortgages, such as fixed-rate mortgages. They finance the purchase of a home, requiring a down payment from the borrower.
The length of the loan and the down payment can vary, just like with traditional mortgages, from 15 to 30 years, and anywhere from 5% to 20% down.
The main difference is an adjustable-rate mortgage bears an interest rate that can change over time, unlike a fixed-rate mortgage, which stays the same during the life of the loan.
With an ARM, the interest rate is typically locked for a few years in the beginning stages of the loan. That way, you won’t have to deal with any uncertainty as you get used to life with a new mortgage payment.
The initial rate is usually lower than the current rate for fixed-rate mortgages.
But once the fixed-rate period is up, the interest rate can change, depending on the current market conditions. It’s normal for interest rates to rise or fall on a regular basis, depending on what’s going on over at the Federal Reserve.
When rates drop, so too will your rate fall, and you’ll enjoy a lower mortgage payment during that time. But if rates rise, your interest rate and the monthly payment will rise.
Variations of the Adjustable Rate Mortgage
Unlike fixed-rate mortgages, where all loans are exactly the same, you have a few options with an ARM. Options come in the form of how long your fixed period lasts, and how many rate changes can occur within a year.
The most popular variation of the ARM is a 5/1 ARM. The fixed-rate period lasts five years. After that, the interest rate can change one time per year.
You can also find lenders, such as Modern Lending, offering a 3/1 ARM, 7/1 ARM, 10/1 ARM, or a few other variations, depending on your specific goals.
Fixed vs. Adjustable Rate Mortgage
So what about fixed-rate mortgages? These are the most common type of mortgage loans.
Most buyers prefer the stability of a fixed-rate mortgage, as they don’t like the thought of their mortgage payment changing every year. It can mess up their budgets and cash flow projections.
They are also afraid of rate increases. So they try getting a low, fixed-rate mortgage, and keep it going for as long as they remain in the home.
But if interest rates drop lower than what a fixed-rate borrower is paying, that borrower won’t benefit unless they refinance their loan to match the current interest rates.
Refinancing means paying closing costs all over again, plus dealing with tons of paperwork. But to avoid overpaying on your mortgage, saving thousands of dollars over time, it’s worth doing.
What About Variable Rate Mortgages?
Adjustable-rate mortgages are also different from variable-rate mortgages. With a variable rate mortgage, there aren’t any periods with a locked interest rate, like an ARM has.
The rate fluctuates from day one, depending on how the market moves. These loans are better for those who plan to stay in a property only for a short time or plan to refinance in the near future.
If you think rates will stay relatively low, then they can work well for a couple of years.
Who Should Get an Adjustable-Rate Mortgage?
ARMs are the ideal loan choice for the homebuyer who knows they won’t stay in a particular house long-term. If you’re buying a house that you plan to live in for less than three, five, or seven years, it makes sense to get an adjustable-rate mortgage, enjoy lower interest rates, and sell the home before the variable rate kicks in.
How long you plan to live in the home is the biggest factor when determining if you should get an ARM or fixed-rate mortgage.
The savings that you enjoy during your locked, low-interest period could help you save up for your dream home that you plan to purchase next.
If you plan to stay in the home past your locked-rate period, then you need to be able to stomach the volatility. Most ARMs only experience rate changes once per year, on the anniversary of your loan. The initial rate change is often uncapped, meaning it can be the biggest change you’ll ever experience.
The remaining changes should be capped, limiting the amount that they can rise or fall during one year.
Some ARMs will change rates multiple times per year, meaning your rate can adjust much more frequently. These ARMs will be clearly labeled as such, so it’s easy to avoid this level of volatility if you prefer.
Timing Your Mortgage
Choosing a mortgage type also depends on the current market conditions. At certain periods of time, mortgage rates hit the bottom, such as during the 2020 and 2021 calendar years, following the initial global pandemic.
Since interest rates have been sitting at rock bottom, it has made much more sense for almost all borrowers to choose a fixed-rate mortgage, as rates can only go up from here.
So if you’re buying a house when rates are at the bottom, fixed-rate is the better option.
Financing Your Dream
Now that you know what an adjustable-rate mortgage is, and how it can benefit homebuyers, you can make a more informed decision. Consider how long you plan to stay in the home you are buying, and what the current interest rate landscape looks like.
Both types of mortgages have their pros and cons, and there are times when one makes more sense than another.
Looking for more home buying tips like this? Head over to our blog now to keep reading.