Is a variable rate mortgage right for you?

If you’re sure you’ll move or pay off your mortgage in 10 years or less, an adjustable rate mortgage, or ARM, may be the best home loan option for you.

There are big differences between an ARM and its counterpart, the fixed rate mortgage, so make sure you are familiar with the details before choosing. Choosing the right loan for your situation now and in the future will help you save money and reduce stress.

Definition of variable rate mortgage

A variable rate home loan is a home loan whose interest rate may change over time. In most cases, a variable rate mortgage will have a low fixed interest rate during the introductory period, which can last as little as three years or up to 10 years.

With a variable rate mortgage, the interest rate and monthly payment can go up or down.

At the end of the introductory period, the interest rate adjusts to current market rates. If current rates are lower, your rate and mortgage payment may go down. But if the current rates are higher than the original rate, your rate and your mortgage payment may increase. ARM rates continue to change periodically, usually once a year, until you sell, refinance, or pay off the mortgage in full.

Types of adjustable rate mortgages

There are many types of ARMs, but they all share the characteristic of a variable rate. Some common types are:

Hybrid ARMs. These mortgages have two phases: a fixed rate period – usually three, five, seven or 10 years – followed by an adjustable phase, during which your interest rate can rise or fall, depending on a chosen market rate index. by your lender. . The frequency with which the rate adjusts and other details about how your ARM works are written into the mortgage contract. Some possible hybrid ARMs:

  • 3/1 ARM. The interest rate is fixed for three years and then adjusts annually.

  • 5/1 ARM. The interest rate is fixed for five years and then adjusts annually.

  • 7/1 ARM. The interest rate is fixed for seven years and then adjusts annually.

  • 10/1 ARM. The interest rate is fixed for 10 years, then adjusts annually.

Interest-only ARM. An interest-only ARM, or OI, gives you a specified number of years, usually between three and 10, during which you only pay interest on your mortgage. Your payments stay low during the fixed rate OI period. But paying interest only does not reduce the loan amount. At the end of the OI period, your payments will be larger, possibly much larger, as they will include both principal and interest.

ARM payment-option. These ARMs, which have become rare since the housing crisis of 2008, allow borrowers to choose between several monthly payment options: an interest-only payment, a minimum payment that does not pay all interest due, or a fully amortizable payment that includes the main one. and interest. These loans are extremely complicated and come with high risks for just about anyone on a budget.

Importance of ARM caps

Variable rate mortgages can have several types of ARM limits, which limit when and how much your interest rate changes. Knowing your mortgage ARM limit can help you avoid financial surprises when your rate adjusts.

It’s important to compare ARM limits when looking for an adjustable rate mortgage lender because they have a big impact on your monthly mortgage payment, as well as the total cost of the loan. Lenders with identical introductory rates may have different ARM caps.

ARM caps limit when and how much your interest rate can change.

  • Initial ceiling: This ARM cap dictates how much your interest rate can change on the first adjustment after your fixed rate expires. The initial adjustment limits are usually 2 or 5 percentage points.

  • Next ceiling: Also known as the periodic or annual limit, this ARM limit controls how your interest changes during the second adjustment and any subsequent annual adjustments. The following ARM caps are generally set at 2 percentage points.

  • Lifetime ceiling: These ARM caps limit the total increase in interest rates as long as you have the loan. Lifetime adjustment limits are generally set at 5 percentage points, but may be higher.

  • Payment limit: This cap indicates the total increase allowed on an ARM payment. While it may seem beneficial at first glance, an ARM payment cap could actually prevent your mortgage payment from fully covering future interest increases. This results in negative amortization, which means your loan balance would go up instead of going down with each payment. Payment caps are rare and should always be approached with caution.

Other important variable rate mortgage conditions

ARMs come with complicated terms and conditions. Understanding them will help you know how the loan works and how your payment may change. Here are some of the terms you’ll hear:

  • Adjustment frequency: How often your interest rate will adjust after the introductory period.

  • Benchmark : The interest rate index to which payment changes on an ARM are linked.

  • Launch or teaser price: The initial interest rate of your ARM, which does not change during the fixed rate period of the loan.

When an adjustable rate home loan is a good idea

Here are some situations where an ARM makes sense. Do any of them look like yours?

  1. You will only own the house for a short time. If you’re moving in 3, 5, 7, or 10 years, an ARM mortgage can save you money. Military families or physicians currently enrolled in a residency program are two examples where this could be the case.

  2. You plan to quickly pay off the total mortgage balance. Do you expect a financial windfall, such as an inheritance or a court settlement, in the coming years? An ARM mortgage can allow you to make smaller monthly mortgage payments until you have complete freedom to own the home.

  3. You expect fixed rate mortgage rates to go down. It’s risky and difficult to predict, but if you expect fixed rate mortgage rates to fall below current ARM rates before your introductory period expires, a variable rate mortgage can save you money. until fixed rates go down. Note that this option requires you to possibly refinance into a fixed rate mortgage, which means choosing a lender, getting approval, and paying closing costs, just like with your ARM mortgage.

When an adjustable rate home loan is a bad idea

An ARM is probably not the right choice if:

  1. You plan to take root. If you are buying your home forever and have no plans to move, a fixed rate mortgage might be the best choice. Although it may have a slightly higher rate, a fixed rate mortgage carries less risk than a variable rate mortgage, so your investment is better protected.

  2. You want a predictable mortgage payment. Of course, the interest rate on a fixed rate mortgage may initially be higher than an ARM, but you never have to worry about it increasing and you are always free to refinance your mortgage if rates drop significantly in the years to come.

  3. Your budget cannot support a larger mortgage payment. You may be thinking about going back to school, starting a family, or starting a business. These life changes could affect your income for years to come. If you are not 100% sure you can handle a mortgage payment which rises when rates adjust upward, stick with the predictability of a fixed rate mortgage.

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