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Understanding the Ins and Outs of Adjustable-Rate Mortgages

What is an adjustable rate mortgage, and why might you consider one for your home loan needs? Here’s a basic primer.

Understanding the Ins and Outs of Adjustable-Rate Mortgages

When you're considering your mortgage options heading into the homebuying process, one of the first important things to think about will be the type of loan you choose. Generally speaking, there are two options: fixed-rate loans and adjustable-rate mortgages (ARMs).  

At Supreme Lending, we often speak with customers about their rate options when assisting them with all their varying home loan needs. This article focuses on an adjustable-rate mortgage -- what it is, what are some examples of how it works, and what are the benefits and potential drawbacks of going this route? Here's what you need to know when considering an ARM.  

Basics on Adjustable-Rate Mortgages 

Also known as variable-rate home loans or floating-rate mortgages, adjustable-rate mortgages refer to those where the interest rate on the loan adjusts periodically. This contrasts to a fixed-rate mortgage, where the interest rate stays constant throughout the life of the loan. The most common type of adjustable-rate mortgage is tied to an index that measures the interest rate by reflecting economic trends, plus a margin. 

With an adjustable-rate mortgage, your monthly payments will usually be lower during the initial fixed-rate period of the loan. After this set period ends, however, your interest rate and monthly payments could rise or fall depending on market conditions. Because of this potential change in payment amount (and because they're often used by borrowers who may not qualify for a fixed-rate mortgage), adjustable-rate mortgages usually come with caps that limit how high your interest rate and payments can increase (more on these in a bit).  

Types of Adjustable-Rate Mortgages 

There are a few different types of adjustable-rate mortgages, each with their own specifications that could affect whether or not this is the right choice for you.  

The most common type of ARM is the hybrid ARM, which refers to a setup where the loan begins as a fixed-rate mortgage, then converts to an adjustable-rate mortgage after a certain number of years. For example, a 30-year 5/1 hybrid ARM would have a fixed-rate for the first five years of the loan, followed by 25 years of an adjustable interest rate (with annual adjustments, in this case).  

Other common types of ARMs you may encounter include Interest-Only ARMs and Payment Option ARMs. Interest-Only ARMs offer a lower initial monthly payment by only requiring you to pay the interest on the loan for a certain period of time (usually 3, 5, 7, or 10 years). Payment Option ARMs, on the other hand, give borrowers even more flexibility in their monthly payments. With this type of mortgage, you'll have the option to make a minimum payment, interest-only payment, or fully amortized payment each month.  

Adjustable-Rate Mortgage Caps 

As mentioned above, many adjustable-rate mortgages will come with what are known as rate caps. These are meant to limit the degree to which payments can fluctuate, and usually take one of three forms:  

  • Initial adjustment cap: This refers to the maximum amount that your interest rate can increase when it first adjusts. For example, if you have a 5/1 ARM with an initial adjustment cap of 2%, that means your interest rate can’t increase more than 2% when it first adjusts after five years.  

  • Subsequent adjustment cap: Once your loan's interest rate has adjusted, this cap limits how much it can increase (or decrease) in subsequent years. Subsequent adjustment caps can either be periodic (from one year to the next) or lifetime (how much the loan can change over its entire lifespan).  

Rate caps are often very important to borrowers, as they provide protection against drastic swings in payments. That being said, it's still important to be mindful of the potential for payment increases when considering an adjustable-rate mortgage.  

Benefits of Adjustable-Rate Mortgages 

There are a few reasons why borrowers might consider an adjustable-rate mortgage instead of a fixed-rate mortgage.  

The biggest perk is usually the lower initial interest rate and monthly payments. This can be helpful if you're trying to qualify for a loan on a tight budget, as it can make the difference between being approved or denied. Additionally, because your interest rate will eventually adjust (likely upward), an ARM could help you stay ahead of rising rates in the future.  

Another potential benefit is that many adjustable-rate mortgages come with built-in rate caps. As mentioned, these limit how high your interest rate and monthly payments can go, giving you some peace of mind that your budget won't be blown up by a sudden increase.  

Drawbacks to Adjustable-Rate Mortgages 

Adjustable-rate mortgages can have potential downsides. The biggest one is the fact that your interest rate and monthly payments could eventually increase, potentially putting a strain on your budget.  

This is why it's so important to be aware of the terms of your loan before signing the dotted line. Make sure you understand how often your interest rate can adjust, as well as what the maximum amount of each increase (or decrease) could be. Additionally, find out if there is a limit to how high your interest rate can go over the life of the loan.  

Another potential drawback is that some adjustable-rate mortgages come with negative amortization. This means that if you make only the minimum required payment, the amount you owe on the loan could actually go up instead of down, resulting in owing more than the value of your home. So, if you're considering an adjustable-rate mortgage, be sure to ask about negative amortization and make sure you understand the terms before moving forward.  

For more info on adjustable-rate mortgages or to learn about any of our home loan services, get in touch with our Loan Officers at Supreme Lending today.