For most Americans, a mortgage is what makes home ownership attainable. By borrowing enough money for a home and committing to monthly payments for 10 – 30 years, families can enjoy the benefits of home ownership without waiting decades to save the whole purchase price in cash.
Still, not all home loans are created equal. While some loans offer a fixed rate that lasts between ten and thirty years, other loans - including ARM loans - offer rates that fluctuate over time.
The best type of loan for each person depends on the individual and their goals. Keep reading to learn more about ARM loans, how they work, and who they're best for.
What is an ARM Loan?
Adjustable-rate mortgages (ARMs) work differently than the fixed-rate loans we've grown accustomed to. Where fixed-rate loans offer interest rates and monthly payments that never change, ARM loans offer interest rates and monthly payments that can rise and fall over time.
Typically speaking, ARM loans offer an introductory rate that lasts for a limited length of time. This introductory offer is extended to entice borrowers into choosing an ARM loan over a traditional, fixed-rate mortgage. Once the intro APR ends, however, the loan transitions to a variable rate loan that adjusts periodically.
Examples of an ARM loan include:
- 7/1 ARM: Your interest rate is set for the first seven years. After that, you'll enjoy a variable rate loan for the next 23 years.
- 5/1 ARM: Your interest rate is set for five years, then variable for another 25 years.
- 3/1 ARM: Your interest rate is set for three years then variable for an additional 27 years.
Benefits and Drawbacks of ARM Loans
While it's easy to imagine a fixed-rate loan would leave you better off, there are several reasons consumers flock to adjustable-rate mortgages.
For starters, the initial – or introductory – interest rates are typically lower than what you can qualify for with a fixed-rate loan. If you only plan to stay in your home for a short amount of time, an adjustable-rate mortgage can make a lot of sense. By locking in the lowest rate possible while you own the home, you'll save money on interest until you sell. And, if the interest rate stays low after the introductory period, you could save even more money on interest over time.
On the flipside, ARM loans come with notable drawbacks. This includes the fact that having a variable rate loan means your house payment could fluctuate over time. Since you have no control over interest rates, you would be stuck with a higher payment until you refinance into a fixed-rate loan. Lastly, ARM loans make long-term budgeting more difficult since you can't always predict what your house payment will be.
Factors that Make ARM Loans Rise and Fall
If you're considering an ARM loan, it's important to understand the factors that influence your loan's rate. In summary, ARM loans follow indexes and margins. After your ARM's fixed rate ends, your rate will move up and down with another interest rate called the "index." The interest rate is set by market forces and can fluctuate greatly over time. To set the rate on your ARM loan, your lender takes the index rate and adds a specific number of percentage points, commonly referred to as the "margin."
Most ARM rates are tied to one of three major indexes: the London Interbank Offered Rate (LIBOR), 11th District Cost of Funds Index (COFI), or maturity yield on the one-year treasury bill.
Keep in mind, however, that there are caps on the amount your rate can surge. Most ARM loans come with a periodic cap that limits how much your rate can change from one year to the next, a lifetime cap that limits the rate of change throughout the life of your loan, or a payment cap that limits how much your monthly payment can rise.
Who Should Get an ARM Loan?
While an ARM loan could work for nearly any homeowner, these financial products tend to work best for certain types of homeowners. You should consider getting an ARM loan if:
- You plan to move and sell after a few years. If you plan to sell your home after a few years, it can make sense to settle for an ARM loan with a lower introductory APR.
- You plan to refinance your home after the introductory APR resets. If your goal is to refinance your home at a later date, you can save money by sticking with the lower introductory APR offered by ARM loans.
- You think you'll earn more money in the future. If you believe you'll earn more money in the future, signing up for an ARM loan with a lower interest rate and monthly payment can make sense in the short-term.
Requirements to Get ARM Financing
The requirements to qualify for an adjustable-rate mortgage are similar to traditional mortgages. For starters, most ARM loans are available to consumers with good or excellent credit, or those with FICO scores of 740 or higher. Most ARM loans require a down payment of 5 percent, although some lenders may require you to put down up to 20 percent.
Lastly, the loan amount for conforming ARM loans is usually limited to $424,100 for a single-family home. However, Jumbo ARMs may help you qualify if you need to borrow more than that amount.
In addition to these requirements, you'll need to be able to illustrate your ability to repay your loan. Just like any other loan, you'll need to show a solid history of employment to qualify.
Comparison Shopping for an ARM Loan
If you're in the market for a home mortgage, and specifically an adjustable-rate mortgage, the smartest thing you can do is shop around. By searching for a mortgage with the best terms and lowest rate, you can save money on interest payments and pay off your loan faster.
As you compare loan products, make sure to see how the introductory interest rates stack up above all else. Since the introductory rate is the main reason people choose an ARM loan, you want to make sure your rate is the lowest it can be.
Once you compare introductory APRs, make sure to look at other loan details such as closing costs and your repayment timeline. A solid mortgage calculator can help you determine how much your monthly payment will be depending on your introductory APR. With enough research, you'll be on the path to finding the ideal ARM loan for your needs.