Adjustable Rate Mortgages

February 24, 2020

Adjustable Rate Mortgages

An adjustable-rate mortgage (ARM) is a type of home loan where the interest rate is fixed for an initial fixed rate period, usually several years, and then adjusts periodically for the remainder of the loan term. This means that after the introductory fixed rate period ends, the interest rate can rise or fall based on changes in an underlying index rate, such as the secured overnight financing rate (SOFR) or the prime rate, plus a fixed margin set by the lender.

During the initial period, borrowers benefit from lower monthly payments compared to fixed rate loans because the initial interest rate is typically lower than that of a comparable fixed rate mortgage. However, once the adjustable rate period starts, the monthly mortgage payment can fluctuate with market interest rates. This variable rate mortgage structure allows borrowers to save money if interest rates drop, but it also carries the risk of higher loan payments if interest rates rise.

Adjustable rate mortgages usually have caps to limit how much the interest rate and monthly mortgage payment can increase at each adjustment and over the life of the loan, providing some protection against steep payment increases. The adjustment period refers to how often the ARM interest rate resets after the initial fixed period, commonly every six or twelve months.

Because of the potential for changing loan payments, ARMs are often suitable for borrowers who plan to sell or refinance before the introductory rate period ends, or who expect their income to increase to handle possible higher payments. Understanding how an adjustable rate mortgage works, including the initial fixed rate period, index rates, margins, rate adjustments, and caps, is essential for making informed decisions about choosing this type of mortgage loan.

An image depicting a financial advisor explaining the concept of an adjustable rate mortgage (ARM) to a couple, highlighting key features such as the initial interest rate, monthly payments, and the differences between fixed rate mortgages and variable rate mortgages. The advisor points to a chart illustrating how interest rates can change over time, affecting the monthly mortgage payment.

Fixed-rate vs. adjustable-rate mortgages

The difference between fixed interest rate mortgages and adjustable rate mortgages (ARMs) is straightforward. Fixed interest rate mortgages maintain the same interest rate for the entire loan term, providing stable monthly payments that include principal and interest payments. This predictability helps borrowers budget effectively throughout the life of the loan.

On the other hand, adjustable ra

te mortgages start with a lower initial rate, often referred to as a teaser rate, during the initial fixed rate period. After this period ends, the adjustable period begins, during which ARM rates adjust periodically based on an index rate such as the secured overnight financing rate (SOFR) or constant maturity treasury, plus a fixed margin set by the lender. These subsequent adjustments can cause your monthly mortgage payment to fluctuate.

ARMs typically include rate caps, such as initial adjustment caps and payment caps, which limit the maximum amount the interest rate or minimum payment can increase at each adjustment and over the life of the loan. However, borrowers should be cautious of risks like negative amortization, which can occur if the minimum payment does not cover the interest due.

Choosing between a fixed interest rate mortgage and an adjustable rate mortgage depends on your financial situation, including your down payment, loan amount, and how long you plan to keep the loan. ARMs offer the advantage of lower interest rates initially, potentially leading to lower monthly payments, but come with the uncertainty of rate changes. Fixed rate mortgages provide payment stability but may have higher initial rates.

Understanding the differences, payment options, and potential impacts on total interest paid can help you make an informed decision. Consulting with a mortgage professional and seeking tax advice is recommended when considering these loan types.

How does an adjustable-rate mortgage work?

ARMs are comprised of a few components:

  • Fixed period: This is the period with the low introductory (and fixed) rate, which lasts for three to 10 years, depending on the loan. In an ARMs-naming convention, this is the first number (for instance, the “7” in “7/1”).
  • Adjustable period: The adjustable period starts after the fixed period ends, continuing until you sell, refinance or pay off the loan.
  • Rate of adjustment: ARMs adjust every six months to a year. This is the second number in the name (the “1” in “7/1” or the “6” in “5/6″). You may see variations of this, such as a 5/5 ARM, which is an ARM that adjusts every five years.

What are ARM rate caps?

ARMs come with rate caps that insulate you from possible steep year-to-year increases in monthly payments. These caps limit the amount by which rates and payments can change.

  • A periodic rate cap: Limits how much the interest rate can change from one year to the next.
  • A lifetime rate cap: Limits how much the interest rate can rise over the life of the loan.
  • A payment cap: Limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.

Adjustable-Rate Mortgage Example

Consider a 5/1 ARM with a loan amount of $300,000 and an initial interest rate of 3.5% fixed for the first five years. During this introductory fixed rate period, your monthly payment remains stable and typically lower than a comparable fixed-rate mortgage. After five years, the adjustable period begins, and the interest rate adjusts annually based on the secured overnight financing rate (SOFR) plus a fixed margin set by the lender.

For instance, if the SOFR is 2% and the lender’s margin is 2.5%, the new interest rate would be 4.5%. However, the rate adjustments are subject to caps, such as a 2 percentage point initial adjustment cap and a 1 percentage point subsequent adjustment cap, limiting how much your interest rate and monthly payments can increase each year. Additionally, a lifetime cap restricts the maximum interest rate increase over the life of the loan, providing protection against steep payment hikes.

This structure allows borrowers to benefit from lower initial interest rates and payments, while also limiting the risk of sudden, large increases in mortgage payments during the adjustable period.

Requirements for an Adjustable-Rate Mortgage Loan

To qualify for an adjustable-rate mortgage (ARM) loan, borrowers generally need to meet certain criteria to demonstrate their ability to manage the loan payments. Common requirements include:

  • Credit Score: Most lenders require a minimum credit score of around 620 or higher. A higher credit score can help secure better interest rates and loan terms.
  • Debt-to-Income Ratio (DTI): Lenders typically look for a DTI ratio of 50% or less, meaning your monthly debts, including the mortgage payment, should not exceed half of your gross monthly income.
  • Down Payment: The amount of down payment varies depending on the loan type and lender, but a larger down payment often improves your chances of approval and may reduce your interest rate.
  • Loan Type Considerations: Requirements can differ based on whether the ARM loan is conventional, backed by the Federal Housing Administration (FHA), or a VA loan. FHA-backed ARMs may have more flexible credit and down payment standards.
  • Income Verification: You will need to provide proof of stable income to assure lenders that you can handle the fluctuating payments after the introductory fixed rate period.

Meeting these requirements helps ensure that borrowers are prepared for the potential variability in ARM payments and can manage the risks associated with adjustable interest rates.

Types of ARMs

Adjustable rate mortgages (ARMs) are typically 30-year mortgage loans, but the duration of the initial fixed interest rate period and the frequency of rate adjustments during the variable rate period can vary significantly. Common ARM loan terms include:

  • 3/6 and 3/1 ARMs: These loans feature a fixed introductory period with a lower initial interest rate lasting the first three years of the mortgage. After this introductory period ends, the loan enters the adjustable rate period for the remaining 27 years. The 3/6 ARM adjusts its interest rate every six months, while the 3/1 ARM adjusts annually.
  • 5/6 and 5/1 ARMs: With a fixed rate period of five years, these ARMs offer lower monthly payments during the introductory fixed rate period. Following that, the interest rates adjust either semiannually (5/6) or yearly (5/1) for the remaining 25 years of the loan term.
  • 7/6 and 7/1 ARMs: These ARMs provide a longer initial fixed interest rate period of seven years, followed by an adjustable rate period where the interest rate resets every six months or annually, respectively, for the remaining 23 years.
  • 10/6 and 10/1 ARMs: Featuring the longest initial fixed rate period among common ARMs at ten years, these loans then adjust their interest rates every six months or once a year during the adjustable period, which lasts for the remaining 20 years.

In addition to these standard loan terms, there are three primary types of adjustable rate mortgage loans: hybrid ARMs, interest-only ARMs, and payment-option ARMs. Each type offers different payment options and structures to suit various borrower needs, influencing the monthly mortgage payment and overall loan payments during the entire loan term.

Pros and Cons of an Adjustable-Rate Mortgage (ARM)

Pros

  • Lower initial interest rates: ARMs typically offer a lower initial interest rate, often called a teaser rate, which results in lower monthly payments during the introductory fixed rate period compared to fixed rate mortgages.
  • Potential savings if interest rates drop: Borrowers can benefit from decreased monthly payments if market interest rates fall during the adjustable period.
  • Suitable for short-term ownership: ARMs can be advantageous for borrowers who plan to sell or refinance before the adjustable rate period starts, allowing them to save money with lower initial payments.
  • More funds for other goals: Lower initial monthly payments may free up cash for other financial priorities, such as saving or investing.
  • Rate caps provide protection: ARMs usually have caps that limit how much the interest rate and monthly payment can increase at each adjustment and over the life of the loan, offering some protection against steep payment hikes.

Cons

Should you get an adjustable-rate mortgage?

There are several reasons why an adjustable rate mortgage (ARM) may be the right choice for you, such as:

  • Lower monthly payments at the start. With an ARM, you benefit from a lower initial interest rate or teaser rate, which leads to lower monthly mortgage payments during the initial fixed rate period. This can help you save money early in the loan term and potentially allocate more funds toward paying down the principal.
  • More budget flexibility. The lower initial monthly payment allows you to manage your finances more effectively, giving you the option to pay more when you have extra cash or less when you need funds for other priorities.
  • You’re planning to sell or refinance. Adjustable rate mortgages are ideal for borrowers who intend to move or refinance before the adjustable period starts. Taking advantage of the low introductory rate period can save you money on interest payments compared to a fixed rate mortgage.
  • You’re comfortable with some risk. After the initial fixed period, ARM interest rates can adjust based on the secured overnight financing rate (SOFR) or another index rate, causing your monthly payment to rise or fall. If you choose not to refinance, your mortgage payments may increase, but they could also decrease depending on market conditions and movements in federal reserve bank policies.

The Bottom Line

  • Adjustable-rate mortgages (ARMs) feature interest rates that adjust at set intervals, such as annually or every six months.
  • These loans usually begin with a lower introductory interest rate, resulting in more affordable monthly mortgage payments during the initial fixed rate period.
  • ARMs are often suited for borrowers who plan to sell their home or refinance before the adjustable rate period begins, allowing them to take advantage of the initial lower payments without facing potential rate increases later.

One proposed solution to the potential problem of more borrowing costs as a result of the volatility with SOFR rates is to have households and businesses borrow at a term SOFR rate that is determined in arrears. Although SOFR can be volatile on a daily basis, its one-month moving average tends to be more or less as smooth as 1-month LIBOR. So, a one-month SOFR rate would be the moving average of the daily SOFR rate over the past month. It is not a perfect relationship, and it is important to bear in mind that a one-month moving average of SOFR is inherently backward-looking, whereas 1-month LIBOR is an inherently forward-looking rate. But consumers should not worry the transition is going to have a material impact on their borrowing costs.

This year Fannie and Freddie will begin accepting mortgages backed by the secured overnight financing rate, or SOFR. And after Freddie and Fannie map this out, Orion and others will establish their policies. The FHFA issued a news release that highlighted certain changes affecting single-family and multifamily ARM products. Companies servicing mortgages are also watching these developments. Most existing ARM loans have notes that contain verbiage regarding an index change, and legal staffs are reviewing those as well.

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