There are two common types of ARMs: hybrid ARMs and interest-only ARMs.
Hybrid ARMs. As explained above, hybrid ARMs combine an initial fixed-rate loan with an adjustable-rate mortgage after the teaser-rate period ends.
Interest-only ARMs. An interest-only ARM allows qualified borrowers to pay only the interest due on the loan for a set time, usually between three and 10 years. During that time the loan balance isn’t paid down at all.
THINGS YOU SHOULD KNOW
There is another type of ARM that is rarely offered, called a payment-option ARM. It allows borrowers to choose different “options” for how they pay their loan. The three choices typically include a principal and interest payment, an interest-only payment and a minimum or “limited” payment.
With the limited payment option, borrowers can opt to pay less than the interest accruing on their mortgage, and add the unpaid interest to the loan balance. They were popular in the years leading up to the 2008 housing crash, and most lenders steer away from them.
Conventional, FHA and VA ARMs
Adjustable-rate mortgage options are available for conventional loans, loans backed by the Federal Housing Administration (FHA) and loans guaranteed by the U.S. Department of Veterans Affairs (VA).
A few things worth noting about ARMs with each type of loan program:
- Conventional ARMs require a higher minimum down payment. You’ll need at least 5% down for an ARM loan compared with only 3% for fixed-rate conventional loan programs.
- FHA ARMs allow lower minimum credit scores and down payments. Borrowers with scores as low as 580 may qualify for an FHA ARM with a 3.5% down payment.
- VA ARMs come with restrictions on yearly adjustments. To protect military borrowers from unaffordable rate increases, the VA caps the initial and subsequent caps to 1% yearly on hybrid ARMs that adjust in less than five years.
When should you choose an ARM?
An ARM loan makes sense if you need to save money over a short period of time. You should choose an adjustable-rate mortgage if:
- You have time-specific savings goals you can accomplish before the initial fixed-rate period ends
- You plan to sell your home or refinance before the first rate adjustment
- You can afford the lifetime maximum payment
- You can’t afford the payment attached to rates on current 30-year fixed-rate mortgages
Fixed rate vs. variable rate: Which is better?
A fixed-rate mortgage is better if you prefer predictability in your monthly principal and interest payment and have long-term plans to stay in your home.
An adjustable-rate mortgage is better if you need to save money for a brief period and have a plan to refinance or sell your home before the initial fixed-rate period is over.
ARM loan requirements
Because of the risk of your monthly payment becoming unaffordable due to ARM loan rate increases, lenders set more stringent qualifying guidelines than fixed-rate mortgages. In general, you’ll need:
Higher credit score minimums. Conventional loans may require a score of 640 versus the standard 620 score for fixed-rate mortgages.
Higher down payment minimums. You’ll need to come up with a higher down payment if you choose a conventional ARM loan to buy a primary residence or vacation home.
Proof you can qualify at the fully indexed payment. Some ARM programs require proof that you can qualify at the “fully indexed” payment, which is typically the maximum payment amount allowed over the life of the loan. Check with your loan officer to make sure you know the guidelines.