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Before you start diving into the home search, it’s important to understand your mortgage options. One of the most common aspects that homebuyers look for in a home loan is a favorable interest rate. But did you know there’s a loan option that periodically changes the interest rate throughout the life of the loan? 

Discover more about adjustable-rate mortgages (ARMs), how they work and when you might want to apply for one below.

 

What is an ARM?

An adjustable-rate mortgage or ARM is a type of home loan in which the interest rate varies at yearly or monthly intervals based on market conditions. ARMs are also known as variable-rate mortgages, floating mortgages or hybrid ARMs. 

Typically, ARMs have lower interest rates than fixed-rate mortgages, at least during the initial fixed period. This may be beneficial to you depending on your specific circumstances or goals. However, after this introductory period, your interest rate can change, unless you sell your home, refinance your mortgage or pay off the debt fully.

 

How Do ARM Rates Adjust?

An ARM has two periods: an initial fixed period and an adjustable period. During the fixed period, the interest rate won’t change. The period lasts between 3 to 10 years, depending on the terms of your loan. During the adjustable period, the interest rate will change according to the market. This is usually once every 6 months to a year but could be more frequent based on the terms of your loan.  

ARMs have caps on how much the interest rate can increase during the adjustable period: 

  • Initial Adjustment Cap: The maximum amount the interest rate can increase the first time it’s adjusted.  
  • Subsequent Adjustment Cap: The maximum amount the interest rate can increase during every adjustment after the first adjustment. 
  • Lifetime Adjustment Cap: The maximum amount the interest rate can increase throughout the life of the loan.

 

Keep in mind that there will never be a surprise change in the interest rates, and they don’t necessarily always increase during the adjustment period. However, you’ll likely want to be aware of how much your payments would change for each cap to ensure you can afford the maximum payment it may change to.

 

Types of ARMs

There are a variety of ARM loan structures you may be able to choose from.  

The way that hybrid ARMs are named indicates the fixed period and frequency of adjustments. The first number is the number of years there is a fixed rate; the second number indicates how often the rate will adjust. A “1” is once a year, while the “6” means every 6 months. For example, a 7/1 ARM has a fixed period of 7 years. After the fixed period, the interest rate would adjust once a year. Here are a couple types of ARM options: 

  • 5/1 or 5/6 ARM 
  • 7/1 or 7/6 ARM 
  • 10/1 or 10/6 ARM 

 

Interest-only ARMs let you pay interest only (and not principal) for a set time frame, which lasts a few months to a few years. After this period, you would make the full payment including principal and interest. 

Lastly, payment-option ARMs allow you to set your own payment schedule and terms including payments covering principal and interest, interest-only or paying a minimum amount without covering interest. Keep in mind that paying the minimum amount may result in your loan balance increasing.

  

When Might You Consider an ARM?

While an ARM can be risky for some people, there are certain scenarios in which it may be beneficial for you.  

You Know You’ll Move

Many borrowers plan to buy a starter home and move after a couple years to a more permanent home. In this scenario, it would be beneficial to take advantage of an ARM’s initial fixed period because of its lower interest rates and subsequent lower monthly payments.

You Can Pay Off the Debt Fast

If you can pay off your mortgage fully within the fixed period, you may be able to save money on interest. That extra money you’ve saved could also be put toward the loan amount to help you pay it off even sooner. This would be ideal in situations where you expect a large amount of money coming your way, like an inheritance, and can pay off your balance fully with these funds.

You Want the Initial Low Interest Rate

In some cases, the fixed period is attractive for borrowers who are comfortable with possible increased payments in the future. During the fixed period, you could save more money or put that money towards other financial obligations and goals. Your savings can also be used as an emergency fund if your interest rate does spike during the adjustment period. If you’re able to pay off as much of the loan during the fixed period but can still take on the risk of increased payments, this loan option could work for you.

 

Consider Your Options

As you’re deciding between a fixed-rate mortgage and an ARM, consider what your living situation will be a few years down the line. This can help you decide whether or not an ARM could be beneficial for your goals. The ability to pay off your loan fast or knowing that you’re going to move from the home can both be situations in which you may want to consider an ARM.

To understand the nuances and details of ARMs, however, it helps to speak with a professional and reputable lender.

This information is intended for educational purposes only. Products and interest rates subject to change without notice. Loan products are subject to credit approval and include terms and conditions, fees and other costs. Terms and conditions may apply. Property insurance is required on all loans secured by property. VA loan products are subject to VA eligibility requirements. Adjustable Rate Mortgage (ARM) interest rates and monthly payment are subject to adjustment. Upon submission of a full application, a mortgage banker will review and provide you with the terms, conditions, disclosures, and additional details on the interest rates that apply to your individual situation.

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