While many home buyers opt for a fixed-rate mortgage, during which the interest rate remains static for the life of the loan, sometimes it makes sense to choose an adjustable-rate mortgage, or ARM. Here are a few features of ARMs that are useful to know if you are choosing a mortgage type:
An ARM carries a set interest rate for a certain length of time – for example, the first five years of the loan. After the initial period has expired, however, the interest rate can fluctuate, often yearly, reflecting current rates.
One of the reasons an ARM can be appealing is because it typically carries an attractive initial interest rate. And depending on prevailing interest rates, the rate on an ARM can actually drop in a favorable climate once the initial rate period expires. Most ARMs carry a monthly payment cap so that even if the interest rate increases, the sky is not the limit in terms of how much a borrower will be expected to pay monthly, which can help with budgeting even if future interest rates climb.
No one can be certain how interest rates might fluctuate over a given period of time. But given that recent interest rates have hit historic lows and are now climbing, it’s a good possibility that rates could continue to increase, meaning an increased monthly mortgage payment after the ARM’s initial rate period expires. And remember that monthly payment cap? That cap is simply for the payment, not for the total amount owed on the loan. So if the interest rate climbs beyond the payment cap, that accrued interest is still owed toward the loan, effectively increasing the borrower’s debt.
A borrower’s budget is a major consideration when choosing an ARM. For those who are not concerned with meeting higher monthly payments, it can be a gamble that is worthwhile. And if a homeowner is planning to pay off a property quickly, to sell again in the short term or “flip” a property, or to refinance sometime before the initial period of the loan expires, it may be appealing to take advantage of an ARM’s initial, attractive interest rate without the concern of a possible rate hike several years down the road. However, a home is a big investment, and many borrowers can’t afford to gamble on interest rates trending downward or to face having to swing larger monthly payments.
If you think that an adjustable-rate mortgage is the right fit for you, talk with your lender to see find out about current interest rates and for advice as to whether an ARM is the right fit for your circumstances. Since no two mortgages are exactly alike, finding a mortgage with the right fit for you is an important step on your path to home ownership.