What is an adjustable rate mortgage?
Why should you go for adjustable rate loan?
- Increase your savings with a low interest rate:
With an adjustable rate loan, you can take advantage of a low initial interest rate (even lower than the rate on a 30 year fixed rate mortgage) at the beginning of the loan. While you pay less initially, it helps you save the money and invest it thereby getting higher returns in future.
Let's take an example: We shall consider 1 year ARM having a loan term of 30 years during which the interest rate changes on a yearly basis. The loan is offered at an interest rate of 5.6% with zero points. Also, we shall consider a 30 year fixed rate mortgage at 7.5% with zero points.
ARM calculator shows that on a loan amount of $250,000, the 1 year ARM will yield a monthly payment of $1435.20. Again, FRM calculator shows that the 30 year fixed mortgage will require a monthly payment of $1748.04. So, there's a difference of $312.84 per month and around $3754.08 for a year.
This extra money can be used to pay off debts, finance home improvement etc.
- Plan to move within a few years:
If you plan to live in the house for only a few years, an adjustable rate mortgage may be the right option for you. For example, you've taken a 5/1 ARM that offers you a low initial rate that'll adjust only after the first 5 years. Now, if you need to relocate within 3 years, then at the end of the third year you can sell off the property and pay down the mortgage. But, make sure that there isn't a prepayment penalty in the loan agreement, and if it does exist, you can afford to pay it.
- Qualify for a higher loan amount:
Since lenders qualify you for ARM on the basis of your gross monthly income and gross monthly payment which is quite low in the initial years, therefore chances are that you can easily get qualified. And, you may even get a bigger loan. Therefore you'll be able to afford a larger home.
- Payments can go down as well:
It's true that the monthly payments on your loan will go up when interest rates rise. But the loan payments can get reduced if the market rates go down. Thus, adjustable rate loans may be risky when market interest rates are up. But there are rate caps and payment caps to limit the increase in rates and monthly payments. However, sometimes, payment caps lead to negative amortization.
When is it suitable to opt for ARM?
- You want to get a loan at low initial rate.
- You want to save more with the low initial payments, so that you can invest the savings.
- You plan to occupy the property for 3-5 years or a maximum of 10 years.
- You feel that you can handle the increased payments when rates go up.
What should you ask yourself before choosing an ARM?
- How long do I plan to occupy the property?
- Can I afford to make higher payments once the interest rates adjust?
- Will I be going for auto loans, credit cards, personal loans etc?
- Do I want to make extra payments on an ARM?
What should you ask lenders when shopping for an ARM?
- Can you convert the ARM into a fixed rate mortgage when rates are low enough? Make sure that you know what conversion actually means and how it will affect you.
- Under what situations can negative amortization occur with your loan? Will the lender alert you about negative amortization? How does the lender handle these cases?
- Does the cap apply to the initial rate or the true/standard rate? For instance, if your initial rate is 4.5% and the lifetime cap is 5.5%, then you may think that the rate will go up to maximum 10%. But if the cap is tied to the true rate, then 10% isn't the maximum rate that you may be offered.
- What if you prepay the loan? Is there any penalty involved?
- If you sell the property, will the lender allow the buyer to assume the mortgage? It is important to ask this because assumption isn't possible without the lender's approval.
How do you choose the best adjustable rate loan?
- Check out the true/indexed rate: When you shop for an ARM, don't just go after the low initial rate (Teaser Rate). Instead, ask the lender about the true rate or current Indexed Rate, that is, what rate you will get after adding the index to the margin, because the Teaser Rate is temporary and after the first rate adjustment, rates will go up. Also, ask if there is a minimum rate as because some lenders may charge the minimum rate even if index goes below that rate.
- Use the margin to compare loans: When comparing adjustable rate mortgages at the same index, check out the one with the lowest margin. There are lenders who may offer a low initial rate but a comparatively higher margin. This will lead to frequent rate hikes and therefore you may have trouble making payments.
- Find out the variations in the index: To make sure that you can manage the changes in the index, you need to ask the lender for a chart that reflects such changes for the past few years. Take a look at a few years of changes in the index. This will help you understand how stable/volatile the index is.
- Check out the adjustment interval: Frequent adjustments bring frequent changes in your payments. Therefore, look for a longer adjustment interval so that your payments don't vary often.
- Look for lifetime cap protection: See that your loan has lifetime cap protection, which prevents the newly adjusted rate from increasing beyond a certain limit even when the market rate gets higher.
- Find out what the periodic rate cap is: Ask the lender what the periodic rate cap is like. See that the rate doesn't go up too high periodically even though on the whole it may be as high as 10% or more. Ask the lender what will happen if rates increase more than the periodic rate cap.
What are the Adjustable rate mortgage types?
- Hybrid ARMs: These are adjustable rate mortgages which have fixed rates for an initial period of time, after which the rates keep changing at regular intervals. For example, the 5/1 year ARM, 3/1 year ARM, etc are hybrid loans. Know more ...
- Interest-only ARMs: This kind of a loan requires you to pay only the interest for a specific time period, between 3-10 years. So, your interest-only payments will be lower during this period. At the end of the interest-only period, your payments will go up even though the interest rates may not increase, because you'll have to pay towards the principal as well as the interest. However, the longer the interest-only period is, the higher your monthly payment will be after the interest-only period is over.
- Pay Option ARMs: This type of loan allows you to choose from a variety of payment options such as a minimum payment plan, interest-only payment, and fully amortized payment plan. However, with the minimum payment plan, the chances of negative amortization are higher. Know more ...
If you're shopping for a home loan and a fixed rate loan isn't that appealing or it doesn't fit your budget, you can try an adjustable rate loan. It's important to assess your financial needs, evaluate your financial strength, and then decide whether an adjustable rate loan can best serve your needs.
- What are the types of ARM index?
- How can you overcome the risks associated with an ARM?
- How does an ARM differ from a fixed rate loan?