One important decision to make when getting a mortgage is whether you want an adjustable-rate mortgage (ARM) or a fixed rate mortgage. Learn more about what these terms mean and their pros and cons to help decide what product is right for you.
What is an ARM?
An ARM is a type of mortgage where the interest rate is not fixed for the loan’s entire life. An ARM’s interest rate is only fixed for a specified period and then adjusts annually based on a benchmark or index interest rate.
An ARM consists of a fixed rate portion, cap, margin, and index.
- Fixed rate portion: The agreed-upon rate that appears on your loan estimate.
- Caps: Limits the amount the rate can change after the adjustment period and protect your rate from rising too high.
- Periodic rate caps limit how much the rate can change from one year to the next.
- Lifetime rate caps limit how much the rate can rise over the life of the loan.
- Payment caps limit the amount the monthly payment can increase over the loan’s life in dollars, rather than how much the rate can change in percentage points.
- Index: An interest rate tied to a specific benchmark, such as the 1 Year Treasury Bill or the LIBOR, that changes based on its market conditions
What are the Different Types of ARMs?
The most common ARMs are 5/1, 7/1, and 10/1.
- 5/1 ARM
A 5/1 ARM interest rate will remain fixed for five years and will adjust every year thereafter based on the index. - 7/1 ARM
A 7/1 ARM interest rate will remain fixed for seven years and will adjust every year thereafter based on the index. - 10/1 ARM
A 10/1 ARM interest rate will remain fixed for ten years and will adjust every year thereafter based on the index.
What are the Advantages of an Adjustable Rate Mortgage?
- Take advantage of a lower rate early in the term.
- Allows borrowers looking to own property for a short amount of time to have access to lower rates for the period they planned on owning.
- Lets borrowers potentially avoid the need to refinance if rates fall after the adjustment period.
- Access to interest-only options
What are the Disadvantages of an Adjustable Rate Mortgage?
- Rates and payments may rise after the adjustment period if market conditions change. This might be a shock to your budget if the increase was unexpected.
- Each ARM can have different caps, margins, and indexes, making it difficult to understand and plan what your rate could look like.
What are Interest-Only ARMs?
An interest-only ARM has a period of fixed rate payments where only interest on the principal is paid. During the interest-only payment period, the borrower will owe the same amount of money each month, regardless of how many payments are made; only the interest is being paid. Once the interest-only period is over, the borrower starts to pay principal and interest. This will result in a higher monthly payment and allow the borrower to pay down the principal loan amount.
The borrower can still make payments on the principal during the fixed term on an interest-only loan. Doing this increases their equity and reduces the balance to alleviate the [future] higher payments after the adjustment. Before taking this action, the borrower should check with their lender to ensure no pre-payment penalty is associated with early payments.
There are stricter restrictions on borrowers looking for this option. There is a higher risk of your monthly payment rising, which can be a shock to your budget, leaving it hard for borrowers to make payments. That is why interest-only options often require borrowers to have higher liquid assets, good credit scores, and income security.
What is a Fixed Rate Mortgage?
A fixed rate mortgage is a fully amortizing loan where the interest rate remains the same over the loan’s entire term. Thus, the monthly payments do not change during the whole course of the loan.
What are the Different Types of Fixed Rate Mortgages?
Fixed rate mortgages can have terms of 30, 20, 15, or 10 years. A 30-year fixed-rate mortgage is the most common mortgage program in the U.S. as it offers borrowers predictability and stability for a housing budget.
The term (30, 20, 15, or 10) determines how many years you will repay the loan. For example, a 30-year fixed rate mortgage is paid back over 30 years. When you pay a loan back over an extended period, you will pay more interest over the life of the loan.
Which Fixed Rate Term is Right for Me?
Choosing the proper loan term for your fixed rate mortgage depends on your financial situation. A shorter-term, such as a 15-year fixed, usually comes with lower interest rates. This allows you to pay less interest over the loan compared to a 30-year fixed. However, the monthly payments will be higher on a 15-year term because the loan principal is paid back over fewer years.
Today we are in a historically low-rate environment, so many homeowners will refinance from an adjustable rate to a fixed rate mortgage to lock in a low rate for years to come.
Should I Get an ARM or a Fixed Rate Mortgage?
The type of loan product you get should depend on your financial situation. You should consider asking yourself the following questions to determine if an ARM or fixed rate mortgage is right for you.
- How long do you plan to live in the home?
If you are looking for your forever home and intend to stay there for more than ten years, then a fixed rate mortgage may be right for you.
- What is the current rate environment?
As mentioned before, today’s rates are at historic lows. If you are fearful that rates may rise soon, then you may want to take advantage of a fixed rate loan to take advantage of the low rates for many years. In a higher interest rate environment, ARMs may be more attractive as they may offer slightly lower interest rates in general.
- What is your budget?
If you are looking for consistency and stability, then a fixed rate mortgage may be best. If you get an ARM, it is essential to plan for changes in your monthly payments and monthly budget to make sure you are prepared for all possible scenarios and can afford the payments.
If you are still wondering if an ARM or fixed rate mortgage is right for you, contact us to get in touch with one of our mortgage specialists. We will evaluate your current financial situation to determine which option is best suited for your credit profile and long-term goals.
