Adjustable Rate Mortgage Pros and Cons – ARM Definition
Guide To Adjustable Rate Mortgages
An adjustable-rate mortgage (ARM) is a kind of mortgage where the interest rate that you pay on your house changes periodically, which impacts the amount that your monthly mortgage payment is. You probably have seen interest rates advertised for ARMS that tend to be lower than the interest rates on conventional mortgages. However, when reading the fine print, you will soon discover that the advertised rate is only the initial rate. That means the rate may change. And most likely it changes in a certain direction: Up!
Whenever you finance your house using an ARM, an initial interest rate is set by the bank that normally is around one point lower than a fixed-rate mortgage interest rate. During the introductory period – the rate stays the same. It is usually one year, five years or sometimes seven years – depending on the kind of ARM is. Then, the honeymoon comes to an end.
Once the introductory period has come to an end, your mortgage rate can be adjusted periodically by the lender until it has reached the authorized capped interest rate, or until the maximum number of authorized adjustments have been used.
Every time the rate is adjusted (which usually happens every year) it changes your monthly loan payment amount. Since in recent years interest rates have actually been historically low, there is a good chance that your lender will be raising the rate in order to compensate for increasing interest rates.
If you are a home buyer that is on a tight budget, an ARM may be attractive due to the low initial rate. However, when you take a closer look, you will discover why it is low: it is because the bank is moving the risk of increasing interest rates over to you when they are betting that the interest rates that are going to be increasing.
When taking an ARM out, you are betting your long-term financial security and yourself.
Understanding the Different Kinds of ARMs
Since mortgage lenders have a lot of flexibility in terms of how your mortgage can be structured, and there is an endless number of different kinds of ARMs. Each of them varies when it comes to an adjustment period, interest rate, introductory period, and other factors. There are a few key terms that you will need to understand in order to figure out the different types of ARMs:
- Initial Rate: The introductory interest rate that is charged by the bank for a certain time period, such as an introductory rate of 3.25%.
- Introductory Period: This refers to how long the introductory rate stays the same before an adjustment can be made by the bank. A three-year introductory period, for example.
- Adjustment Period: This is how often your interest rate can be adjusted by the bank after the introductory period has come to an end.
Most adjustable rate mortgages are marketed as a set of two numbers, like a 3/1 ARM. What a 3/1 ARMS mean, is your introductory rate period is for three years, and then your rate can be changed once per year by the bank. The first number indicates how long your introductory rate is, and then the second number tells you how often the rate can be adjusted by the lender.
However, different terms are used by the banks in their advertising, so things can get quite confusing. That is because there isn’t a standardized, one way that lenders describe their ARMs. It is very important that you understand the different aspects of this type of loan, from the adjustment period to the interest rate. Some sources refer to the pars as “components” or “elements.”
How Are The Rate Adjustments Calculated?
Your mortgage agreement will state that the rate may be adjusted periodically. This means that the mortgage provider gets to decide when to change the rate usually based on prevailing market conditions and the index rate. Different providers use different indexes and the type of index rate will be stipulated in your mortgage agreement.
The most common index is the London Interbank Offered Rate or LIBOR. So when the LIBOR market index increases, you are more than likely to experience an increase in your mortgage rate. Your mortgage agreement may also state that your rate could go down however this is very rarely the case.
Some ARMs may also use the Prime Interest Rate that is published by the U.S. Federal Reserve to calculate adjustments. Fannie Mae and Freddie Mac can also factor into calculating an increase in your rate.
Whichever index rate or method of calculating your mortgage lender uses, you can be certain that all adjustments that are made will not go in your favor. Although the rate may go down, mortgage market trends are currently pointing at an increase.
Are Fixed Rate Mortgages A Better Option?
A conventional mortgage with a fixed interest rate removes the risk of a rate hike over the entire term of your mortgage. The mortgage provider assumes all the risk associated with rate increases rather than you. After all, it is the provider that is profiting from the transaction and therefore should carry the risk.
ARMs are less popular than in the past. The low introductory period rates are often attractive but it is the increases in the rate, as and when the mortgage provider sees fit, that makes these loans unpredictable which can result in you paying much more to service the loan than you thought you could afford.
Fixed interest rate mortgages mean that your interest rate will never increase giving you the security and stability to plan financially for your future not having to compensate for unforeseen interest rate hikes.
To find out more about the benefits of fixed-rate mortgages and how to avoid the pitfalls of adjustable rate mortgages, contact The Texas Mortgage Pros. They will advise you on a mortgage option to best suit you and your family’s short and long term needs.