An adjustable-rate mortgages (also known as ARM loans) are home loans carrying an interest rate that adjusts after a fixed period of time (typically 5 and 7 years). After the fixed period of time, the rate adjusts to a financial index, such as the Treasury Bill or London Interbank Offered Rate (LIBOR).
ARMs typically deliver lower rates, because they transfer part of the “interest rate risk” from the lender to the borrower. Borrowers benefit when the interest rate falls, but banks benefit when the interest rate rises. ARMs can be used when an unpredictable market makes it difficult to predict and deliver fixed rate loans.
In other words, ARMs permit borrowers to lower their initial payments if they’re willing to assume some moderate interest rate risk. To keep this in check, charges on rate adjustments are limited with “caps.” Caps are a common feature of ARMs, and they limit the total rate change over the life of a loan.
Advantages of ARM Loans
- Quick financial boost- Although somewhat riskier than a fixed rate mortgage, an ARM may be beneficial for certain needs and circumstances, as it might provide your finances with a short-term “boost.” A low initial fixed rate can free up money early on but remember to avoid additional debt or absorbing a higher cost of living to the point that you can’t afford the higher payment after your rate adjusts. Examine your financial and life situation with the help of your loan officer or financial advisor.
- Qualify for more house – Obtaining an ARM can allow you to qualify for a higher loan amount, and therefore a more valuable house. Many people with exceptionally large mortgages get 1-year ARMs and refinance these loans every year. The low rate allows them to buy a more expensive home with the lowest mortgage payment possible.
What would cause you to move or upgrade in the next few years? Why obtain a higher rate 30-year fixed rate mortgage if a job transfer or twins are in the future? An ARM could be a better (and cheaper) way to go. If you’re considering a short length of stay (1-10 years), then the benefits of getting an ARM are enhanced, as you’ll enjoy lower rate and payment with less risk. Ask your loan officer to help you crunch the numbers. If you plan to refinance or sell soon, read your current loan documents carefully. Some contracts stipulate a penalty for early loan payoffs.