Adjustable-Rate Mortgages: How They Work and What to Know

An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate can change over time. Unlike a fixed-rate mortgage, where the interest rate stays the same through the life of the loan, an ARM can go up or down based on market conditions.

Key Takeaways

Here's How It Works

1. 1. Initial Rate and Period: An ARM starts with an initial interest rate usually lower than the rate for fixed-rate mortgages. This rate lasts a set period, often 5, 7, or 10 years.
2. 2. Adjustment Period: After the initial period, the interest rate adjusts regularly. For example, a "5/1 ARM" means the rate is fixed for the first five years and can change yearly after that.
3. 3. Rate Caps: ARMs have caps that limit how much the interest rate can change during each adjustment period and over the life of the loan. This protects you from drastic increases in your monthly payments.
4. 4. Indexed Rate: The adjusted interest rate is tied to a financial index (like the LIBOR or the Treasury index) plus a set margin. Your interest rate and monthly payments can change accordingly when the index goes up or down.

Conclusion

The main advantage of an ARM is the lower initial interest rate, which can make your home more affordable in the short term. However, there's a risk that your rate and monthly payments could increase significantly over time, depending on market conditions. It's a good choice if you plan to sell or refinance your home before the rate adjusts or if you expect your income to rise in the future.

FAQs

1. How do I decide between an ARM and a fixed-rate mortgage?

Choosing between an ARM and a fixed-rate mortgage depends on your financial situation, how long you plan to stay in your home, and your tolerance for risk regarding potential rate increases. An ARM might save you money if you move or refinance before the adjustable period starts. However, a fixed rate might be better if you prefer predictable payments for budgeting or plan to stay in your home long-term.

2. What happens if interest rates skyrocket after my ARM adjusts?

If interest rates increase significantly, your ARM's monthly payment can improve within the limits of your loan's rate caps. Understanding these caps and how much your payment could increase is essential. It is necessary to ensure you can still afford your mortgage in a worst-case scenario.

3. Can I refinance my ARM to a fixed-rate mortgage if rates rise?

If you're concerned about rising interest rates, you can refinance your ARM to a fixed-rate mortgage. Refinancing might allow you to lock in a new, fixed interest rate. Still, it's essential to consider the timing, costs, and potential savings of refinancing based on current rates and your financial situation.