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How Adjustable Rate Mortgages Work

When it comes time to choose the right type of mortgage for your new home or refinance, one of the most significant decisions you’ll make is whether to go with a fixed rate mortgage or an adjustable rate mortgage (ARM).

A fixed-rate mortgage is a popular choice among borrowers who want the stability and predictability of an interest rate that never changes. However, your unique financial goals and plans for the future may make an ARM the better choice for you.

So, what exactly is an ARM, and how does it work? Keep reading to find out.

WHAT IS AN ADJUSTABLE RATE MORTGAGE?

An adjustable-rate mortgage (ARM) is a mortgage with an interest rate that adjusts over time based on market conditions.

This type of loan varies from a fixed-rate mortgage, which maintains the same interest rate throughout the life of the loan.


HOW DOES AN ADJUSTABLE RATE MORTGAGE WORK?

An ARM offers a fixed interest rate for a set period. Once the initial rate period expires, your interest rate will adjust at designated intervals to follow. You will often see these terms expressed in fractions, indicating the number of years your rate will be fixed, followed by the adjustment period, or how often the interest rate will change.

To highlight this, let’s use First Heritage Mortgage’s 15/1 ARM as an example. In this scenario, the interest rate is fixed for 15 years, followed by a rate adjustment each (1) year after.

When the rate adjusts, your interest rate can increase or decrease based on market conditions. Each rate adjustment is based on a benchmark interest rate or index, plus an additional spread called the margin. There are also limits called rate caps that help protect your rate from changing too drastically. Depending on market fluctuations, this new rate may lower your monthly payments, though your monthly payment may rise as well.

For more information about how the index affects your adjustable-rate mortgage, visit the Consumer Financial Protection Bureau.

PUTTING IT ALL TOGETHER

Let’s put all of these elements together. Imagine that a lender offers a customer a 30-Year 7/1 LIBOR ARM at 3.00% with 2/2/5 caps.

ARM ElementElement NameElement Example7/1 (the 7 in the 7/1)Initial fixed rate periodHow long the initial fixed rate remains in effect.

The initial rate on the loan is 3.000% for the first 7 years of the mortgage.7/1 (the 1 in the 7/1)Adjustment periodHow often the interest rate will be adjusted.

The adjustment period is 1 year. After 7 years, the interest rate can adjust once a year for the remaining 23 years of the mortgage.LIBORIndexThe economic indicator used to calculate the interest rate adjustments for this loan.

The annual rate adjustment in our example loan is based on changes in the London Interbank Offered Rate (LIBOR) index. Other common indexes include The Prime Rate, Monthly Treasury Average, Federal Funds Rate, and more.2/2/5 capsInitial capThe maximum amount the rate can change the first time it’s adjusted after the fixed period ends.

The interest rate will not increase nor decrease by more than 2% in the first adjustment period.2/2/5 capsPeriodic capThe maximum adjustment amount allowed from one adjustment period to the next.

The interest rate will never adjust more than 2% above or below the previous rate.2/2/5 capsLifetime capThe maximum adjustment amount allowed over the life of the loan.

The interest rate cannot increase more than 5% above the initial rate (3.000% + 5% = 8.000%).


WHY CHOOSE AN ADJUSTABLE RATE MORTGAGE?

So why would you opt for an ARM instead of a fixed rate mortgage?

The key benefit is that the starting interest rate is typically lower on an ARM than a fixed-rate mortgage.

Thinking of moving or refinancing within a few years? If you are planning to sell the home before the initial fixed rate period of your ARM expires, you can take advantage of the lower initial rate and mortgage payments while you live in the home, and then sell or refinance before it’s time for the rate to change.

Buying a starter home? An ARM may be something to look into. Thanks to the lower initial interest rate of ARM, you’ll save a bit on your monthly mortgage payments. You can sell the home before your fixed rate period ends and roll those savings into your move-up home.

Flipping a fixer-upper? ARMs can be a smart option if you’re buying an investment property with the intention of flipping or selling as soon as renovations are complete. If you’re able to sell the home before your rate adjusts, the lower mortgage payments during your ARM’s initial fixed rate period will be less impactful on your profit margin.

Find an extended initial fixed-rate period? A major benefit of programs with an extended initial fixed-rate period, like FHM’s 15/1 ARM, is the ability to have stable, predictable payments for half the length of your loan term while taking advantage of the lower introductory interest rate.


IS AN ADJUSTABLE RATE MORTGAGE RIGHT FOR YOU?

ARMs can be an excellent choice depending on your needs as a homebuyer. Buyers who plan to move or refinance in the next few years might benefit the most from this option and the generally low introductory rates.

Ultimately, you and your lender will need to work together to decide on the best mortgage solution for your unique needs.

Our local mortgage experts are here to help answer any questions you may have as you get ready to take the next steps in this exciting process!

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