Most people have to take out a mortgage in order to buy the home of their dreams. Usually, home buyers end up taking out a 30-year fixed-rate mortgage. However, you have other options. One of those options is an adjustable-rate mortgage, also known as an ARM mortgage. Adjustable-rate mortgages are very different from the typical fixed-rate mortgage. Here's what you need to know.
What Is an Adjustable-Rate Mortgage
An adjustable-rate mortgage is a type of mortgage that does not have a set interest rate over the entire repayment period. Instead, the interest rate may adjust over time based on an interest rate benchmark and a set premium as documented in the loan documents. The payment may change during the repayment period as the interest rate adjusts.
Types of Adjustable-Rate Mortgages
One of the most common adjustable-rate mortgages is the hybrid ARM. A hybrid arm has an initial period with a fixed interest rate followed by regular interest rate adjustments on a predetermined schedule. For instance, a bank may offer a five-year fixed interest rate period followed by annual interest rate adjustments. The adjustments may have a maximum rate adjustment depending on the specifics of your loan.
Another type of adjustable-rate mortgage is the option ARM. The interest rate on an option ARM will adjust as interest rates change, usually on a monthly basis. However, you'll have many monthly payment options to choose from including a minimum payment, an interest-only payment, a payment based on a 15-year amortization of your mortgage and a payment based on a 30-year amortization of your mortgage. Option ARMs can be complex so make sure you understand all the nuances of the option ARM before you decide an option ARM is best for you.
Why Get an Adjustable-Rate Mortgage
Adjustable-rate mortgages may be the right choice for you for a few reasons. You'll benefit up front with an adjustable-rate mortgage as the initial interest rate is usually lower than a comparable 30-year fixed-rate mortgage. This works to your benefit if you decide to move or refinance your mortgage before the initial fixed-rate period on a hybrid ARM expires.
Advantages of Adjustable-Rate Mortgages
Adjustable-rate mortgages can be very advantageous if you expect interest rates will decrease in the future. As your mortgage interest rate adjusts, your interest rate may actually decrease and lower your payment. Additionally, since adjustable-rate mortgages usually have a lower initial interest rate than a typical 30-year fixed-rate mortgage, you could very well qualify for a larger loan to buy a bigger home or a home with nicer finishes.
If you decide to make extra principal payments, your payment may decrease based on the new principal amount owed at your next payment reset date, unlike with a traditional 30-year fixed mortgage. If you choose an option ARM, you'll have flexible payment options that allow you to pay off your mortgage faster or slower based on the payment options detailed in your loan agreement and what your current finances can handle.
Drawbacks of Adjustable-Rate Mortgages
ARM mortgages have drawbacks, too. While you may predict interest rates will decrease in the future, they can unexpectedly increase as well. If interest rates increase quickly, you could be left with a much higher mortgage payment than during the initial fixed rate portion of a hybrid ARM.
The lower initial interest rate may lure you into buying more home than you can truly afford. You should always be prepared to make a payment based on the maximum interest rate possible under your ARM loan agreement. That worst case payment could become a reality if interest rates make a turn for the worst and you can't sell your home or refinance your mortgage. Changing interest rates and the resulting changes in your monthly mortgage payment can also make budgeting and long term financial planning more difficult as no one can accurately predict future changes in interest rates.
Option ARMs can be bad for your finances if you always find yourself picking the lowest payment options. You could end up owing more than your home is worth. Minimum payments may also increase to a level that is not affordable if both the principal owed and interest rates are increasing when you're having a tough time with your finances.
Requirements for Adjustable-Rate Mortgage Financing
If you want to get an adjustable-rate mortgage, you'll need to meet your lender's minimum requirements for a loan. However, different lenders offer different ARM loan programs that have different qualification requirements. You'll usually have to have a minimum credit score and keep your mortgage payment under a particular debt-to-income ratio. You may need a down payment, although the size may vary depending on the lender and loan program you choose.
Comparison Shopping for Adjustable-Rate Mortgages
Just like with any mortgage, it makes sense to comparison shop for an ARM mortgage. Different lenders offer different rates and closing costs which could result in a significant savings for you. After you've determined what type of adjustable-rate mortgage you want, get multiple quotes for the same type of adjustable-rate mortgage from competing lenders. Then, compare the closing costs and interest rates to see which mortgage will cost you the least amount of money over the time period you plan to live in your home. If you want to avoid the hassle of contacting multiple lenders yourself, you can get multiple mortgage quotes on LendingTree.