With rates on the rise, many homebuyers are investigating adjustable-rate mortgages (ARMs), so how do you know if an ARM is right for you? Of course, ARMs are not for everyone; however, in a rising rate environment, many first-time homebuyers will look to an ARM which may have a lower introductory rate than a 30-year fixed-rate mortgage. While the lower initial rate can be very enticing, the interest rate adjusts after a set number of years and could adjust up or down periodically for the life of the loan.
Here are four things that you should know about adjustable-rate mortgages:
1. ARMs could be a great option when rates for a conventional fixed-rate mortgage are on the rise
ARMs may provide a money-saving option in a rising interest rate environment. Having a lower mortgage rate can help borrowers in two ways:
- Buy a home for the same price you planned and have a lower monthly mortgage payment.
- Keep your monthly payment the same but afford a more expensive property.
Mortgage lenders determine you loan amount based on your debt-to-income ratio (DTI). The lower initial interest rate on an ARM potentially gives borrowers more purchase power.
2. Adjustable-rate mortgages have an interest rate that changes during the life of the loan
After the initial period during which your rate is fixed, your interest rate will adjust. The purpose of the adjustment is primarily to bring the interest rate on the mortgage in line with market rates—the interest rate on an adjustable-rate mortgage increases or decreases based on published index. There is a margin associated with the rate that is a pre-determined percentage which is added to the index to determine the interest rate that the payment is based on.
Interest rate = index + margin
3. Borrowers need to qualify for more than the introductory rate
When applying for an ARM, borrowers typically need to qualify for the initial interest rate plus two percentage points. This ensures the borrower can still make monthly payments under the possibility of future interest rate increases. However, keep in mind that it is also possible that rates could drop, and the payment could decrease.
4. The amount your ARM rate can increase is capped
ARMs of the past had much higher margins, indexes were not as stable as those that are being used currently, and many consumers were not educated about how they worked. Thus, ARMs got a bad reputation. ARMs have interest rate caps that limit the amount the interest rate, and monthly payments can adjust on the reset dates. Borrowers should know these caps before closing on their loans and prepare for potential payment changes.
Initial adjustment cap – An initial adjustment cap limits how much the interest rate can change at the first adjustment.
Periodic adjustment cap – A periodic adjustment cap limits how much your interest rate can change from one adjustment period to the next. Usually, a six-month adjustable-rate mortgage will have a one percent periodic adjustment cap, while a one-year adjustable-rate mortgage will have a two percent periodic adjustment cap.
Lifetime cap – A lifetime cap sets the maximum and minimum interest rate you may be charged for the life of the loan. Most ARMs have caps of 5% or 6% above the initial interest rate.
ARMs provide the right borrowers with great opportunities to recognize significant savings or buy nicer homes. Be sure that you fully understand this product and your homeownership goals before choosing an adjustable-rate mortgage. The only way to know for sure is to contact a loan officer and allow them to help you explore your options.