An adjustable-rate mortgage (ARM) is a loan with an interest rate that can change over time. This is in contrast to a fixed-rate mortgage, where the interest rate remains the same throughout the life of the loan. ARMs are often used by borrowers who expect interest rates to fall in the future. However, it is important to understand the risks involved with ARMs before you decide if one is right for you.
Introduction
Adjustable-rate mortgages (ARMs) are a type of home loan that offer a lower interest rate than fixed-rate mortgages for a set period of time, typically the first 5, 7, or 10 years of the loan. After this initial period, the interest rate on an ARM can adjust up or down every year, based on a specific index. This means that your monthly mortgage payments could increase or decrease over time.
ARMs can be a good option for borrowers who expect interest rates to fall in the future, or who are comfortable with the risk of their monthly payments increasing. However, it is important to understand the risks involved with ARMs before you decide if one is right for you.
Here are some of the key features of ARMs⁚
- Adjustable interest rate⁚ The interest rate on an ARM can change over time, based on a specific index.
- Initial fixed-rate period⁚ ARMs typically have an initial fixed-rate period, during which the interest rate will not change.
- Adjustment period⁚ After the initial fixed-rate period, the interest rate on an ARM can adjust up or down every year.
- Margin⁚ The margin is a fixed amount that is added to the index to determine the interest rate on an ARM.
- Cap⁚ The cap is a limit on how much the interest rate on an ARM can increase or decrease each year.
Here are some of the benefits of ARMs⁚
- Lower initial interest rate⁚ ARMs typically offer a lower interest rate than fixed-rate mortgages for the initial fixed-rate period.
- Potential for savings⁚ If interest rates fall, you could save money on your monthly mortgage payments with an ARM.
Here are some of the risks of ARMs⁚
- Interest rate risk⁚ The interest rate on an ARM can increase over time, which could lead to higher monthly mortgage payments.
- Payment shock⁚ If the interest rate on your ARM increases significantly, you could experience payment shock, which is when your monthly mortgage payment becomes unaffordable.
- Prepayment penalty⁚ Some ARMs have prepayment penalties, which means you could be charged a fee if you pay off your loan early.
How ARMs Work
Adjustable-rate mortgages (ARMs) work by using a specific index to determine the interest rate on the loan. This index is typically based on the cost of funds for banks, such as the prime rate or the LIBOR (London Interbank Offered Rate).
The interest rate on an ARM is calculated by adding a margin to the index. The margin is a fixed amount that is set by the lender.
For example, if the index is 3% and the margin is 2%, the interest rate on the ARM would be 5%.
The interest rate on an ARM can change every year, based on the movement of the index. If the index increases, the interest rate on the ARM will also increase. If the index decreases, the interest rate on the ARM will also decrease.
Here is an example of how an ARM works⁚
Let’s say you take out an ARM with an initial interest rate of 3%. The ARM has a 5-year fixed-rate period, which means that the interest rate will not change for the first 5 years of the loan.
After the initial fixed-rate period, the interest rate on the ARM will adjust every year, based on the movement of the index. If the index increases by 1% each year, the interest rate on the ARM will also increase by 1% each year.
After 5 years, the interest rate on the ARM would be 8%. After 10 years, the interest rate on the ARM would be 13%.
It is important to note that the interest rate on an ARM can only increase or decrease by a certain amount each year. This is known as the cap. The cap is typically set at 2% or 3%.
Here are some of the factors that can affect the interest rate on an ARM⁚
- The index⁚ The index that is used to determine the interest rate on an ARM can have a significant impact on the cost of the loan.
- The margin⁚ The margin is a fixed amount that is added to the index to determine the interest rate on an ARM.
- The cap⁚ The cap is a limit on how much the interest rate on an ARM can increase or decrease each year.
Benefits of ARMs
Adjustable-rate mortgages (ARMs) can offer a number of benefits to borrowers, including⁚
- Lower initial interest rates⁚ ARMs typically have lower initial interest rates than fixed-rate mortgages. This can save you money on your monthly payments in the early years of the loan.
- Potential for lower long-term interest rates⁚ If interest rates fall in the future, the interest rate on your ARM will also fall. This could save you a significant amount of money over the life of the loan.
- Flexibility⁚ ARMs offer more flexibility than fixed-rate mortgages. For example, you may be able to choose the length of the fixed-rate period and the frequency with which the interest rate adjusts.
Here are some examples of how ARMs can benefit borrowers⁚
- A borrower who expects interest rates to fall in the future may choose an ARM with a low initial interest rate and a low cap. This could save the borrower a significant amount of money over the life of the loan.
- A borrower who needs a low monthly payment in the early years of the loan may choose an ARM with a low initial interest rate and a long fixed-rate period. This could help the borrower qualify for a larger loan amount.
- A borrower who wants to be able to refinance the loan in the future may choose an ARM with a short fixed-rate period. This will give the borrower the flexibility to refinance the loan if interest rates fall.
It is important to note that ARMs also come with some risks. Before you decide if an ARM is right for you, it is important to understand both the benefits and the risks involved.
Risks of ARMs
Adjustable-rate mortgages (ARMs) can also come with some risks, including⁚
- Interest rates could rise⁚ If interest rates rise in the future, the interest rate on your ARM will also rise. This could increase your monthly payments and make it more difficult to afford your home.
- Your monthly payments could increase⁚ When the interest rate on your ARM adjusts, your monthly payments will also increase. This could make it difficult to budget for your housing expenses.
- You could lose your home⁚ If you are unable to make your mortgage payments, you could lose your home to foreclosure.
Here are some examples of how ARMs can harm borrowers⁚
- A borrower who expects interest rates to fall in the future may choose an ARM with a low initial interest rate and a high cap. If interest rates rise, the borrower’s monthly payments could increase significantly, making it difficult to afford the home.
- A borrower who needs a low monthly payment in the early years of the loan may choose an ARM with a low initial interest rate and a short fixed-rate period. If interest rates rise, the borrower’s monthly payments could increase significantly after the fixed-rate period ends.
- A borrower who wants to be able to refinance the loan in the future may choose an ARM with a long fixed-rate period. If interest rates fall, the borrower may not be able to refinance the loan at a lower interest rate.
It is important to note that ARMs are not suitable for all borrowers. Before you decide if an ARM is right for you, it is important to understand both the benefits and the risks involved.