When ARMs Are More Appropriate Than Fixed-Rate Mortgages
Home buyers are using adjustable-rate mortgages (ARMs) as financial planning tools. ARMs come with lower interest rates, lower monthly payments, and only a tiny bit of extra risk.
Adjustable-Rate Mortgages (ARMs) Give You Control
An adjustable-rate mortgage (ARM) may be more appropriate for your next home loan than a fixed-rate one.
Adjustable-rate mortgages are 30-years loans where the interest rate changes once per year, but only after a certain number of years have passed.
Lenders name ARMs for these initial “fixed rate” periods.
ARMs that don’t change rates for five years are known as 5-year ARMs. ARMs that don’t change rates for seven years are known as 7-year ARM.
And, so on.
As a buyer, you get to choose the number of years that your ARM remains in a “fixed-rate” status. You get to control your loan, which is good. You also get a lower interest rate as compared to the conventional 30-year fixed rate mortgage.
It’s why buyers who aren’t buying their “forever home” tend to find the 5- and 7-year ARM — with their lower rates and monthly payment — to be a perfectly suitable loan.
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The Difference Between ARMs & Fixed-Rate Loans
The most important thing to know about adjustable-rate mortgages is that they’re neither better nor worse than a comparable fixed-rate loan.
Some situations call for an ARM. Some situations don’t. ARMs are just one of many ways that today’s home buyers can pay for and afford a new home.
The most significant difference between ARMs and fixed-rate mortgages is this: ARM interest rates change over time and fixed-rate interest rates don’t.
Thankfully, mortgage lenders regulate and limit ARM adjustments.
Mortgage rates can’t adjust more than a handful of percentage points off the original start rate — up or down — and the direction of the U.S. economy determines in which direction the rate will go.
When the economy’s doing well and banks are paying more interest on savings, ARM mortgage rates adjust higher. Similarly, when the economy’s not doing well and interest payments are falling, ARM rates drop.
Between 2005 and 2016, ARM mortgage rates adjusted lower almost exclusively.
Technical Facts: Adjustable-Rate Mortgages
Adjustable-rate mortgages account for less than ten percent of government-backed mortgages, a classification which includes FHA mortgages, conventional mortgages, and VA loans.
ARM market share is opposite for non-government-backed loans.
Jumbo loans and other loans exceeding local mortgage loan limits are financed almost exclusively via ARMs, and that’s because such loans can’t be government-guaranteed; lenders make those loans against their book of business.
For lenders, adjustable-rate loans offer a hedge against changing economic conditions. Fixed-rate loans can’t do the same, which is why jumbo ARM mortgage rates are often much lower than fixed-rate ones.
Here’s the vital mortgage terminology for ARMs:
- Initial period: The number of years until the loan’s first adjustment
- Start rate: The interest rate that stays in place until the first adjustment
- Index: The variable in the adjusted-rate formula, typically LIBOR
- Margin: The constant in the adjusted-rate formula, typically 2.50%
- Cap: The maximum allowable change to the adjusted-rate, typically ±2.00% per year
And, here’s how ARMs work:
- The borrower chooses the number of years in their loan’s initial period
- The borrower also chooses their lender and starting interest rate
- When the ARM’s initial period ends, the rate adjusts to (Index) + (Margin)
- The lender confirms that the adjusted rate doesn’t exceed the allowable Cap
- If the adjusted rate surpasses the Cap, the adjusted rate rolls back
Adjustments are made every year on the loan’s anniversary until the mortgage’s 30-year term is complete.
ARMs can be an excellent way to save money on your mortgage; paying only for the years you need.
Talk to a mortgage lender about your adjustable-rate mortgage options and see whether choosing an ARM can be an excellent way to help you buy a home.
Where To Get ARM Mortgage Rates
Most mortgage lenders offer adjustable-rate mortgages of some type, and it’s good to know your home loan options.
Adjustable-rate mortgages shouldn’t be used to increase how much home you can afford. They should be used to help you get the best price for your mortgage based on the amount of time you plan to live in your current home.
If you plan to move in the next decade, a 7-year ARM may be smarter than choosing a 30-year fixed-that comes at a premium interest rate.
ARMs help you do more with what you have.
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