An adjustable-rate mortgage, or ARM, is a type of home loan that has an interest rate that can change over time, depending on the market conditions. Unlike a fixed-rate mortgage, which has a constant interest rate for the entire loan term, an ARM has a lower initial rate that is fixed for a certain period, usually between one and 10 years. After that, the rate can adjust up or down, depending on an index and a margin, at regular intervals, usually once a year.
An ARM can be a good option for some homebuyers who want to take advantage of lower initial rates, especially if they plan to move or refinance before the rate adjusts. However, an ARM also comes with some risks and challenges, such as higher interest rates, payment shocks, and negative amortization.
In this blog post, we will cover the following topics:
- How does an ARM work and what are the different types of ARMs?
- What are the benefits and drawbacks of an ARM?
- How to compare and choose the best ARM for your situation?
- How to refinance an ARM to save money or reduce risk?
- How to avoid common mistakes and pitfalls when getting an ARM?
By the end of this post, you will have a better understanding of how an ARM works and how to use it wisely and responsibly. You will also learn some tips and tricks to save money and avoid unnecessary fees and charges. You will also discover some alternatives to an ARM that may be more suitable for your financial goals.
How does an ARM work and what are the different types of ARMs?
An ARM works by having two main components: the index and the margin. The index is a benchmark interest rate that reflects the general market conditions, such as the prime rate, the LIBOR, or the Treasury rate. The margin is a fixed percentage that is added to the index to determine the actual interest rate of the ARM. The margin is set by the lender and does not change over the life of the loan.
The interest rate of an ARM is usually expressed as the index plus the margin, or the fully indexed rate. For example, if the index is 3% and the margin is 2%, the fully indexed rate is 5%. However, the fully indexed rate is not the actual rate that you pay on your ARM. The actual rate is usually lower than the fully indexed rate, especially at the beginning of the loan term, because of the initial rate or the teaser rate.
The initial rate or the teaser rate is a discounted rate that is offered by the lender for a certain period, usually between one and 10 years. The initial rate is usually lower than the fully indexed rate, which makes the monthly payments more affordable and attractive for the borrower. However, the initial rate is not guaranteed for the entire loan term, and it can change after the initial period expires.
The frequency and the amount of the rate change depend on the adjustment period and the rate caps of the ARM. The adjustment period is the time between the rate changes, usually once a year, but it can also be monthly, quarterly, or semiannually. The rate caps are the limits on how much the rate can change at each adjustment and over the life of the loan. For example, a 2/2/5 cap means that the rate can change by up to 2% at each adjustment, by up to 2% in the first year, and by up to 5% over the life of the loan.
There are different types of ARMs that have different features and terms. Some of the most common types of ARMs are:
- Hybrid ARMs: These are ARMs that have a fixed-rate period followed by an adjustable-rate period. The fixed-rate period can range from one to 10 years, and the adjustable-rate period can range from 15 to 30 years. The most popular hybrid ARMs are the 5/1 ARM, the 7/1 ARM, and the 10/1 ARM, which have a fixed-rate period of five, seven, and 10 years, respectively, followed by a one-year adjustable-rate period.
- Interest-only ARMs: These are ARMs that allow you to pay only the interest on the loan for a certain period, usually between three and 10 years. After that, you have to pay both the principal and the interest, which can increase your monthly payments significantly. Interest-only ARMs can be hybrid or non-hybrid, depending on whether they have a fixed-rate or an adjustable-rate period.
- Payment-option ARMs: These are ARMs that give you the option to choose from different payment amounts each month, such as a minimum payment, an interest-only payment, or a fully amortizing payment. However, the minimum payment is usually lower than the interest due, which means that the unpaid interest is added to the principal, resulting in negative amortization. Payment-option ARMs can also have a recast period, which is the time when the loan is recalculated based on the current interest rate and the remaining loan balance, which can increase your monthly payments substantially.
What are the benefits and drawbacks of an ARM?
An ARM can have some benefits and drawbacks that you should consider before getting one. Here are some of the pros and cons of an ARM:
Pros:
- Lower initial rate and payment: An ARM can offer a lower initial rate and payment than a fixed-rate mortgage, which can help you save money and afford a larger or more expensive home. This can be especially beneficial if you plan to move or refinance before the rate adjusts, or if you expect your income to increase in the future.
- Rate adjustment can be favorable: An ARM can also have a rate adjustment that is favorable for you, depending on the market conditions. If the index goes down, your interest rate and payment can also go down, which can help you save money and pay off your loan faster. However, this is not guaranteed, and you should be prepared for the opposite scenario as well.
- More options and flexibility: An ARM can also offer more options and flexibility than a fixed-rate mortgage, as you can choose from different types, terms, and features of ARMs. You can also customize your ARM to suit your needs and preferences, such as the length of the fixed-rate period, the frequency and the amount of the rate change, and the payment options.
Cons:
- Higher interest rate and payment: An ARM can also have a higher interest rate and payment than a fixed-rate mortgage, especially after the initial period expires and the rate adjusts. This can increase your monthly expenses and reduce your cash flow. This can also make it harder for you to budget and plan for the future, as you may not know how much your payment will be each month.
- Payment shock and negative amortization: An ARM can also cause payment shock and negative amortization, which are two of the most common pitfalls of ARMs. Payment shock is the sudden and significant increase in your monthly payment due to a rate adjustment, which can make it difficult for you to afford your loan. Negative amortization is the increase in your loan balance due to paying less than the interest due, which can reduce your home equity and increase your debt.
- Predatory and risky lending: An ARM can also be a predatory and risky lending practice, as some lenders may use deceptive or abusive tactics to lure you into an ARM that you cannot afford or understand. Some lenders may offer you a low teaser rate that is too good to be true, or hide the fees, penalties, and terms of the ARM in the fine print. Some lenders may also target borrowers who have bad credit or low income, and charge them higher rates and fees.
How to compare and choose the best ARM for your situation?
If you decide to get an ARM, you should compare and choose the best ARM for your situation. Here are some tips on how to do that:
- Shop around and compare lenders and loan options: You should shop around and compare lenders and loan options before applying for an ARM, as different lenders may offer different rates, fees, and terms. You should also compare the APR, which is the total cost of the loan, including the interest rate and the fees. You can use online tools like NerdWallet or Bankrate to find and compare the best ARM rates and lenders.
- Understand the features and terms of the ARM: You should also understand the features and terms of the ARM, such as the index, the margin, the initial rate, the adjustment period, the rate caps, and the payment options. You should also read the loan agreement and disclosure carefully and ask the lender any questions or clarifications you may have. You should also use a mortgage calculator to estimate your monthly payment and the total cost of the loan under different scenarios.
- Consider your financial goals and risk tolerance: You should also consider your financial goals and risk tolerance before getting an ARM, as an ARM may not be suitable for everyone. You should think about how long you plan to stay in the home, how much you can afford to pay each month, and how comfortable you are with the uncertainty and variability of the interest rate and payment. You should also have a contingency plan in case the rate or payment increases beyond your budget.
How to refinance an ARM to save money or reduce risk?
If you already have an ARM, you may want to refinance it to save money or reduce risk. Refinancing is the process of replacing your existing loan with a new one, usually with better terms and conditions. You can refinance your ARM to a fixed-rate mortgage or another ARM, depending on your situation and goals.
Here are some reasons and tips to refinance your ARM:
- To save money: You may want to refinance your ARM to save money if the interest rate or payment of your ARM is higher than the current market rate or payment. You can refinance your ARM to a fixed-rate mortgage or another ARM with a lower interest rate, a longer fixed-rate period, or more favorable rate caps.
- To reduce risk: You may want to refinance your ARM to reduce risk if the interest rate or payment of your ARM is unpredictable or volatile, and you want more stability and certainty. You can refinance your ARM to a fixed-rate mortgage or another ARM with a longer fixed-rate period, a lower margin, or more favorable rate caps.
- To change the loan term or features: You may want to refinance your ARM to change the loan term or features if your financial situation or goals have changed, and you want to adjust your loan accordingly. You can refinance your ARM to a shorter or longer loan term, depending on whether you want to pay off your loan faster or lower your monthly payment. You can also refinance your ARM to a different type of loan, such as an interest-only or a payment-option loan, depending on your preferences and needs.
To refinance your ARM, you should follow these steps:
- Shop around and compare lenders and loan options: You should shop around and compare lenders and loan options before refinancing your ARM, as different lenders may offer different rates, fees, and terms. You should also compare the APR, which is the total cost of the loan, including the interest rate and the fees. You can use online tools like [NerdWallet] or [Bankrate] to find and compare the best refinance rates and lenders.
- Calculate the break-even point and the savings: You should calculate the break-even point and the savings of refinancing your ARM, which are the time and the amount that you need to recoup the costs of refinancing. You can use online calculators like [Zillow] or [Realtor] to estimate your break-even point and savings. You should refinance your ARM only if the break-even point is shorter than the time you plan to stay in the home, and the savings are significant enough to justify the costs.
- Prepare and submit your refinance application: You should prepare and submit your refinance application to the lender of your choice, after you have chosen the best loan option for your situation. You will need to provide some basic information and documents, such as your name, address, phone number, email, Social Security number, income proof, bank account details, and employment verification. You will also need to pay for some fees, such as the appraisal fee, the origination fee, and the closing costs.
- Wait for your refinance approval and closing: You should wait for your refinance approval and closing, which can take from a few weeks to a few months, depending on the lender and the loan option. You will receive a loan estimate and a closing disclosure from the lender, which you should review carefully and sign. You will also need to attend the closing meeting, where you will sign the final loan documents and receive the new loan funds.
How to avoid common mistakes and pitfalls when getting an ARM?
When getting an ARM, you should be careful and avoid some common mistakes and pitfalls that may cost you more money or put you in danger. Here are some of the things you should avoid when getting an ARM:
- Not understanding the features and terms of the ARM: You should understand the features and terms of the ARM, such as the index, the margin, the initial rate, the adjustment period, the rate caps, and the payment options. You should also read the loan agreement and disclosure carefully and ask the lender any questions or clarifications you may have. You should also use a mortgage calculator to estimate your monthly payment and the total cost of the loan under different scenarios.
- Not comparing lenders and loan options: You should compare lenders and loan options before getting an ARM, as different lenders may offer different rates, fees, and terms. You should also compare the APR, which is the total cost of the loan, including the interest rate and the fees. You should also check the lender’s reputation, license, and accreditation before applying for a loan.
- Not planning for the future and the worst-case scenario: You should plan for the future and the worst-case scenario when getting an ARM, as the interest rate and payment of your ARM can change over time, depending on the market conditions. You should think about how long you plan to stay in the home, how much you can afford to pay each month, and how comfortable you are with the uncertainty and variability of the interest rate and payment. You should also have a contingency plan in case the rate or payment increases beyond your budget, such as refinancing, selling, or modifying your loan.
- Not shopping for the best time and the best rate: You should shop for the best time and the best rate when getting an ARM, as the interest rate and payment of your ARM can vary depending on the market conditions and the timing of your application. You should monitor the market trends and the index movements, and apply for an ARM when the rates are low and stable. You should also lock in your rate with the lender, which means that the lender will guarantee your rate for a certain period, usually between 30 and 60 days.