All You Need to Know About Adjustable Rate Mortgages

However, they can also be risky if you don't understand what you're getting into—which is why it's essential to know everything there is to know about ARMs before you sign up.

You might be wondering why these mortgages are so popular when the traditional fixed-rate mortgages are already out there in the market. In this post, we’ll cover everything you need to know about these prevalent adjustable-rate mortgages.

This will help you make an informed decision before applying for one of these loans or refinancing your current home loan. Read on to find out more.

Reaching the Absolute Best Adjustable

An adjustable-rate mortgage (ARM) can be an excellent choice for qualified borrowers, but shopping around and deciding which one is right for your financial situation can be daunting.

The variables—fees, loan terms, initial interest rates, and how quickly they'll adjust—make choosing one of these loans tricky.

So if you are going to select an ARM instead of a fixed-rate option, you must understand what makes them tick. However, if you're in it for the long haul, adjustable-rate mortgages may be worth considering.

While most people think of adjustable-rate mortgages as mortgages with interest rates that change, there’s more to these loans than just their interest rates. These mortgages allow rates that change periodically during a set period (the adjustment period).

It provides you with an opportunity to take advantage of historically low-interest rates without sacrificing flexibility if things change in the future. Unlike with fixed-rate loans, you can’t predict what future rates will be like with your ARM.

Where Does an ARM's Interest Rate Come From?

The interest rate on an ARM is usually set at a level above what's called a base rate. Your lender often sets the base rate, but it could also be placed at prevailing market rates. The precise mechanism depends on your lender and the type of loan.

Either way, if market rates go up after you take out your mortgage, so will your monthly payments—even if nothing else changes in your life.

Like conventional loans, adjustable-rate mortgages (ARMs) have both an interest rate and a corresponding payment.

But there's a big difference - ARMs use an index that's pegged to a financial market—like rates on 10-year Treasuries—to determine how much your loan costs over time. If that sounds complex, it is—and it opens up room for surprises down the road.

So before exploring more, be sure to understand the following essential terms:

• Index - An index is a number that represents a variety of things and is calculated using a specific method. Banks use indices to indicate overall economic health, predict future movements in different markets, and understand how much it’ll cost them to lend you a loan.

• Margin - This term is most often used concerning interest rates associated with adjustable-rate mortgages (ARMs). When you take out an ARM, your mortgage lender will calculate how much profit they'll make from your borrowed money based on a margin. That percentage value, expressed in points, is what we call your initial or starting margin. Most loans have a margin of 2.5%, but the precise margin depends on the lender and the index they're using.

• Interest Rates - This is the sum of the loan index and the margin. It's the exact amount you'll pay on your loan, and it's subject to certain limitations.

How Often Does the Interest Rate Adjust?

Most lenders often adjust interest rates every 6 to 12 months. This is a little confusing for some home buyers, but it doesn't mean that your mortgage will increase every six months.

Instead, it means that your lender has changed how they calculate your monthly payment amount. However, monthly adjustments are usually a red flag for negative amortization loans.

While an ARM might seem attractive with lower monthly payments, these loans often have introductory teaser rates that can balloon and lead to a negative amortization loan.

In short, a loan with negative amortization is one in which your outstanding principal balance increases instead of decreases due to extra interest charges. That said, it's vitally important to avoid any adjustable with negative amortization.

The initial interest rate on an ARM is fixed for a specific duration. After that, it can be adjusted annually or more frequently.

Typical adjustable-rate mortgage limits how often and how much rates can change. Because ARMs give homeowners more flexibility over their monthly payments, lenders typically limit how often interest rates can be adjusted.

These limits, also called rate caps, affect every potential adjustment following the end of your initial rate span.

Bottom Line

Adjustable-rate mortgages, commonly referred to as ARMs, have been the subject of much discussion over the last few years.

If you're planning to buy your first home or refinancing an existing home loan, you might be thinking about an adjustable-rate mortgage (ARM).

But are ARMs the best option? These mortgage products are more flexible than traditional fixed-rate options, but it's essential to understand that flexibility comes at a cost and isn't appropriate for everyone.