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What Is an Adjustable Rate Mortgage (ARM) & What Are Its Benefits?

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One of the most important elements of any mortgage is the interest rate. But not every mortgage interest rate stays the same throughout the loan's term. In fact, your loan may be an adjustable-rate mortgage instead.

Today, let’s explore what an adjustable rate mortgage is and the homebuyer benefits of taking this mortgage out when purchasing a new property.

What Is an Adjustable Rate Mortgage (ARM)?

An adjustable-rate mortgage or ARM is a real estate loan that uses a variable interest rate rather than a fixed interest rate. With a traditional or fixed-rate mortgage, the interest rate for the loan stays the same over time no matter how the housing market changes, how the national interest rate shifts, etc.

Adjustable-rate mortgages are the opposite. ARMs usually have interest rates that start off lower than the interest rate you would receive with a fixed-rate mortgage. However, adjustable-rate home loan interest rates are subject to real estate market shifts, so they can become higher than fixed-rate mortgage interest rates over time.

Advantages of Adjustable Rate Mortgages

  •     Lower interest than fixed-rate
  •     Potential to pay more principal monthly
  •     Rates might lower in the future 

Lower Interest Than Fixed Rate

There are several advantages to adjustable-rate mortgages that make them attractive financing solutions for many homeowners.

For starters, ARMs usually offer lower interest rates than fixed-rate mortgages, at least in the beginning. For instance, if you have the option between a fixed-rate mortgage and then an adjustable-rate mortgage, the former may have an interest rate of 7% while the latter may have an interest rate of 5%.

Furthermore, adjustable-rate mortgages always have the ability to retain a lower-than-average interest rate for the life of the loans. In practice, this doesn't always occur, but you may, in the aggregate, enjoy a lower-than-average interest rate for your mortgage loan if market conditions are favorable for 20 to 30 years.

Potential To Pay More Principal Monthly

Adjustable-rate mortgages give you the potential to pay more money toward your loan’s principal each month than with fixed-rate mortgages. Since the initial interest rate for an ARM loan is often lower than the rate you get with a fixed-rate mortgage, you can use this as an opportunity to put more towards your principal every month, that you may not have been able to afford if you secured a higher fixed interest rate. 

Rates Might Lower in the Future

Even if you start out with a decently low-interest rate with your ARM, there's always the possibility that the rate might decrease even further. If you have an adjustable-rate mortgage with a 6% interest rate, you could have an interest rate of 4% the next year, and so on.

Rate adjustments are not predictable 100% throughout a loan’s term. This is why the adjustment period for any ARM loan is important and can affect your monthly mortgage payment’s average cost over time.

Risks Attached to Adjustable Rate Mortgages

  •     Rates can rise in the future
  •     Monthly payments can vary
  •     Some caps can lead to negative amortization 

Rates Can Rise in the Future

It’s important to recognize that adjustable-rate mortgages do have some potential downsides as well.

 

For example, the variable interest rates attached to ARMs can rise in the future. You may start off with an interest rate of 5% but end up with an interest rate of 9% if market conditions are not favorable.

In this way, taking out an adjustable-rate mortgage is betting that the housing market will be favorable for your needs in the long run, especially since, in some years, you may pay more toward interest payments than your loan's principal than if you took out a fixed-rate mortgage.

Monthly Payment Can Vary

The monthly payment for your mortgage can vary from year to year or, in the case of some loans, from every six months to the next six months. For some homeowners, this volatility isn’t very attractive.

Many people budget around having an expected mortgage payment each month that does not fluctuate, similar to other bills. You should only take out an adjustable-rate mortgage if you're comfortable with your monthly payment varying (for better or worse) over the course of the loan's term.

Some Caps Can Lead to Negative Amortization

Because interest rates can rise beyond what you anticipate, you may experience negative amortization. Regular amortization means you gradually pay down your loan’s principal, so each successive interest payment is less than the former.

If the interest rate increases, you may not actually decrease the principle for your mortgage by any meaningful amount with each payment. This results in negative amortization. You’ll have to take longer to pay off your mortgage loan with a variable interest rate than if you took out a fixed-rate mortgage. The interest rates for fixed-rate mortgages are always calculated to never result in negative amortization.

3 Examples of Adjustable Rate Mortgages

  1. 5/1 ARM Mortgage
  2. 10/1 ARM Mortgage
  3. 7/1 ARM Mortgage

Let’s take a look at some examples of ARM mortgages so you can better understand these loan types.

5/1 ARM Mortgage

5/1 ARM mortgages are mortgages with fixed interest rates for the first 5 years. After the 5 years are up, the interest rate shifts into a variable state, and it changes every year (this is what the second number in the "5/1" represents). The initial interest rate for the loan’s term can impact what down payment you’re comfortable with and more.

The ARM loan products with the shortest fixed rate period usually offer the best initial interest rate. This makes 3/1 ARM and 5/1 ARM the most popular option for many homebuyers and investors. However, getting a shorter fixed-rate period means you have less time to take advantage of your lower fixed rate and you will need to move quickly if you decide you want to refinance before the fixed rate period ends. 

10/1 ARM Mortgage

10/1 ARM mortgages are mortgages with fixed interest rates for the first 10 years. After the 10 years are up, the interest rate shifts into a variable state, and it changes every year (this is what the second number in the "10/1" represents). The initial interest rate for the loan’s term can impact what down payment you’re comfortable with and more.

For example, you may take out a 10/1 ARM mortgage with a fixed interest rate of 5% for the first 10 years. However, after the 10th year arrives, the interest rate becomes variable and subject to any value within a band of 3% to 10%. On the 11th year of the mortgage, the interest rate goes up to 7%. In the 12th year, he goes down to 4%.

10/1 ARM mortgages can be advantageous for many of the same reasons that other ARM mortgages are, with the added benefit of having 10 years of interest rate predictability. If you take out a 10/1 ARM with a 30-year term, you can expect 20 years of changing payments or 20 years of variable interest rates.

7/1 ARM Mortgage

7/1 ARM mortgages are similar to 3/1 ARMs and 10/1 ARMs. They have fixed interest rates for seven years, then variable interest rates for the remainder of the loan’s term. Furthermore, the loan’s interest rate shifts every year after the first seven years are up.

If you take out a 7/1 ARM, you can expect 23 years of fluctuating interest rates, assuming a standard 30-year mortgage term.

The Bottom Line: Should You Opt for an ARM?

In the end, adjustable-rate mortgages are tools you can use to get lower payments for a specific timeframe. If you take advantage of an adjustable-rate mortgage's fixed interest rate period, you may enjoy a reduced interest rate compared to a traditional or fixed-rate loan. Later, you can refinance or take advantage of a quick loan exit before the interest rate increases.

ARMs can be advantageous for homebuyers, foreign national borrowers, and rental investors. According to Vaster's VP of Lending, the benefit of an ARM is oftentimes, "not so much the payment, but the programs it represents." Portfolio products, like those held on lenders' books instead of being sold to secondary markets, are excellent examples.

If you aren’t sure whether you should opt for an ARM after this guide, Vaster can help. Whether you plan to buy in the next few months or next year, our team can walk you through all of your options and help you achieve wealth through real estate. Contact us today for an introduction call with a mortgage expert. 

Sources:

Fixed-Rate vs. Adjustable-Rate Mortgages: What's the Difference? | Investopedia

Adjustable-Rate Mortgages | Consumer Finance Protection Bureau

What is negative amortization? | Consumer Financial Protection Bureau

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