ARM LOANS 101 – WHAT YOU MUST KNOW
05 Aug, 2021
When you take out a mortgage, you have many options including a fixed-rate or adjustable-rate loan. Many people automatically choose the fixed-rate loan because it’s what they know. In some situations, though, the ARM loan is a great option.
Here’s what you must know.
What is an ARM Loan?
An ARM loan or adjustable-rate mortgage is a loan with an interest rate that changes. It has a fixed period (introductory period) where the interest rate remains fixed, and then it adjusts annually according to the index and margin set for the loan.
Let’s say for example you take out a 5/1 ARM. The loan would have a fixed rate for the first five years, which is usually a rate lower than fixed-rate borrowers get. After the fifth year, the rate adjusts annually on the adjustment date.
The rate adjusts according to the chosen index, such as LIBOR, plus the margin, which is a preset number. Let’s say the margin is 1% and the LIBOR is 2.3%. Your rate for the year would be 3.3% (these are hypothetical numbers).
On the next adjustment date, the same thing would happen, the rate would adjust according to the current LIBOR index plus the margin.
Terms to Know
ARM loans have more terms you should know than fixed-rate loans have. Understanding these terms will help you understand the ‘best and worst’ part of the ARM loan.
- Adjustment interval – Most ARM loans adjust annually, but don’t assume. Find out the adjustment interval to make sure it’s something you’re comfortable having.
- Initial cap – This is the maximum amount your interest rate can change with the first rate change. If your initial cap is 2.5%, your rate can’t adjust more than 2.5% for the first year only.
- Subsequent caps – This is the maximum amount your interest rate can change for each adjustment. If the cap is 2% and your rate increased 2% last year, it could increase another 2% this year as long as it doesn’t hit its lifetime cap.
- Lifetime cap – This is the maximum amount the interest rate can increase over its lifetime. If the cap is 6% and in 2 years, the rate hits the 6% increase, it can’t go any higher, but it can decrease.
Pros and Cons of the ARM Loan
Choosing a mortgage type and term is a big decision. It affects your finances for the next 30 years, so knowing the good and bad of the ARM loan can help you make that decision.
- You may have a lower rate to start. Most ARM loans have a lower initial rate than the fixed-rate that’s available. You could save money in the first few years of the loan. If you’re moving before the rate adjusts, you’ll save the most money.
- Your payments may go down. If the index your ARM is using decreases, you’ll pay less interest when your rate adjusts. The rate lasts for an entire year, so you could save money on interest for 12 months and potentially invest the savings back into your principal balance.
- There are caps on the interest rate changes. You don’t have to worry about excessive interest rate changes since there are initial, subsequent, and lifetime caps.
- You can refinance it at any time. If you stay in the home and don’t want the risk of an adjusting rate, you can refinance out of the ARM at any time, especially at the end of the introductory period.
- You can’t predict what your rates will do. You could end up with a much higher monthly payment than you anticipated if the rate increases. If you can’t afford the new payment, it could put your home at risk.
- Your plans may not work out. If you took an ARM loan because you thought you’d move in 5 years, but things didn’t work out that way, you’re stuck with an adjusting mortgage unless you can afford to refinance.
- The rate difference isn’t always worth the hassle of the ARM. Adjustable-rate loans are complicated and if you don’t end up saving much money on interest, it may not be worth the hassle it caused.
Should you Choose an ARM Loan?
Choosing an ARM loan is a personal decision, but here are some questions you can ask yourself:
- Is your home purchase temporary? If you think you’ll move in a couple of years, you may save money with the lower initial interest rate.
- Will you make more money in the future? If you have a job that you know the income will increase significantly in a few years (such as a doctor or lawyer), an ARM loan can help you save money now when your income is lower, and you’ll have peace of mind knowing you can afford a higher payment when your income increases.
- Can you handle the adjusting rate? With rates changing annually, it can be frustrating to budget. Some people need predictability and wouldn’t do well with an ARM.
- Is this your ‘forever’ home? If this is the home you plan to be in for the future, an ARM may not make sense. The predictability of a fixed rate and the reassurance that you won’t be subjected to higher rates if the indexes increase is worth the peace of mind.
ARM loans have their time and place. For some borrowers they work great; it’s just important to understand how they work, and the worst-case scenario should rates increase. If you can afford the loan at its highest rate, go for it and enjoy the savings the introductory period offers.
If you need more predictability or don’t know that you could afford a more expensive loan in future years, consider a fixed-rate loan and enjoy its stable rates.
If this is something you’d like to explore, or at least discuss, call us at Valley Mortgage – 701-461-8450. An ARM mortgage may, or may not, be the right loan type in your situation.