Many home buyers who choose the adjustable rate mortgage (ARM) loan do it to save money during the first few years. But later, many of these same homeowners run into trouble when their ARMs adjust to higher interest rates.
In many cases, these adjustments or “resets” can greatly increase the size of the overall mortgage payment, and this catches some people off guard. In this guide, we will examine the adjustable rate mortgage in more detail. After reading this guide, you will better understand the ARM loan and when it makes sense to use one.
What Is an ARM?
An adjustable-rate mortgage differs from a fixed-rate loan in the way it adjusts to a new interest rate at some future point in time. Fixed mortgages carry the same interest rate through the entire life of the loan. So the interest rate you pay in year 1 would be the same rate as years 5, 10, 15 … all the way through the end of the loan’s term.
An adjustable-rate loan, on the other hand, has an interest rate that will change periodically. This can cause payments to go up or down, depending on the prevailing rate at the time of adjustment (and other factors).
In other words, an adjustable rate mortgage is a loan with an interest rate that changes at some point in the future. Most of the time, ARM loans start off with a lower monthly payment than a fixed rate mortgage. But keep the following points in mind:
* Unlike a fixed-rate mortgage, the payments on an ARM loan can change over time.
* You cannot predict what interest rates will be three or five years from now, when your ARM loan adjusts.
Key Ingredients of the Adjustable Rate Mortgage
To get an even better understanding of how the ARM loan works, you must understand the key ingredients of such a loan.
* Initial Rate – We have already discussed how an adjustable-rate mortgage loan starts off with a relatively low interest rate in the beginning. This is known as the initial rate, and it will stay in place for a limited period of time — usually 1 to 5 years. But here’s the thing to remember. On most ARM loans, the initial interest rate (and by extension the initial payment amount) can vary greatly from the rates and payments you would face later in the loan’s term.
* Adjustment Period – This is just what it sounds like, the period during which your adjustable-rate mortgage adjusts to a new interest rate (and payment amount). In most cases, the rate will change annually (after the initial period).
* Interest Rate Caps – Rate caps are an important concept in the world of adjustable-rate loans. A cap is just what it sounds like. It limits how much your interest rate can increase. Rate caps come in two versions: 1. Periodic adjustment caps limit how much the interest rate can go up or down from one adjustment to the next (after the first adjustment). 2. Lifetime caps limit the amount it can rise over the entire life of the loan. Lifetime caps are required by law, so you’ll find them on nearly all adjustable rate mortgage loans.
* Payment Caps – Many ARM loans also cap (or limit) the amount your monthly payment can increase at the time of each adjustment. So if your adjustable rate mortgage loan had a payment cap of 8%, your monthly payment would not increase more than 8% over your previous payment amount.
Is an adjustable-rate mortgage loan right for you? Think about your long-term plans, as well as your appetite for risk and uncertainty. You’ll find the answer within.