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Buying a home takes more than saving up for a mortgage and finding your perfect home. It also includes finding the right type of mortgage that works best for your budget—the loan term, interest rate, and monthly payment all play into what you can afford. An adjustable-rate mortgage (ARM) may be something to consider when looking at different borrowing options.
What is an adjustable-rate mortgage?
An ARM, sometimes called a variable-rate mortgage, is a loan with an interest rate that fluctuates or fluctuates over the life of your loan. Other loans typically have a fixed rate, with the interest rate not changing over the life of the loan.
ARMs usually start out with lower interest rates than fixed-rate loans, but can increase (or decrease) over time.
How does an adjustable-rate mortgage work?
With a fixed-rate loan, you pay a fixed amount each month for the term of your loan, such as 15, 20 or 30 years. If you have the same loan with the same lender, your mortgage payment will not change.
Adjustable-rate loans, on the other hand, have interest rates that fluctuate. In most cases, the amount remains the same for a certain period of time depending on the type of lender and RM you choose. This means that the amount is the same for the first month or up to five years. For example, if you get a 5/1 ARM, your rate will be fixed for the first five years and variable for the rest.
Depending on the terms you agree with your mortgage lender, your payment may change from one month to the next, or you may not see a change for months or years.
Related: Current ARM rates
Types of ARM
There are a few different types of ARMs: hybrid, interest-only, and payment option.
If you see a purchase option like a 5/1 or 7/1 ARM, that’s a hybrid adjustable-rate mortgage. For such loans, the interest rate is fixed for a certain number of years – for example, three, five or seven. After that initial period, the amount is adjusted annually or may be more or less, depending on the terms set by the lender.
The first number is how long the interest rate will be fixed and the second number is how often it will change after the first period. For example, using our same example above, a 5/1 ARM means that the rate is fixed for five years and then variable every year thereafter.
An interest-only (IO) loan means you only pay interest for a certain number of years before you have a chance to pay off the principal balance. With a traditional fixed-rate loan, you pay a portion of the principal and a portion of the interest each month, but your total payment never changes.
With an IO home loan, you will have smaller monthly payments that increase over time as you eventually start paying off the principal balance. The longer your IO period, the bigger your monthly payments will be after the IO period ends. Most IO periods last between three and 10 years.
With an ARM payment option, you have a few different ways to repay your loan.
- Traditional: This method involves the traditional division of principal and interest. It’s similar to a fixed-rate mortgage, where you pay a portion of your principal and interest each month. This is the only option to reduce your debt on your loan.
- On demand only: With this loan, you have the option of paying only the interest for a certain period of time, usually a few years, and then you pay both the interest and the principal for the rest of the loan. While paying the interest alone may seem appealing, it can add costs on the back end when it’s time to start paying off the loan balance.
- low (or limited) You can make the minimum payment on this one, but any interest you don’t pay will be added to the principal balance of the loan, meaning you’re paying interest on top of interest. This option can be hard on your finances – because when your loan expires, regardless of your financial situation, you are responsible for the entire balance.
Advantages and disadvantages of ARM
While an ARM is one way to pay off your home loan, it’s not always the best way for everyone. Be sure to weigh the pros and cons before choosing this option.
Advantages of ARM
- Low primary level: ARMs tend to have lower initial interest rates than fixed-rate mortgages. If you qualify for a low-interest ARM, you can pay much less in upfront interest.
- Fluctuations can mean a decrease in demand: While there is a chance that your interest rate will go up, it could also go down. Since the rate is based on a benchmark, you may see a lower interest rate than fixed loans.
- Payment limits: While interest rates can go up, ARMs have payment limits, which limit how much your lender can increase. The cops control how often the lender advances the amount. So, while your rate may increase somewhat, you may not experience as big of an increase as you think.
Disadvantages of ARM
- Possible price increase: After the initial period, your interest rate is usually set to increase annually. If you’re not prepared for the adjustment, you may end up with bill increases that you can’t afford.
- Complex structures: There isn’t just one type of ARM – there are many. Because of this, it can be confusing. If you don’t understand all the moving parts and do your research, you could end up paying more than you expected.
ARM vs. Fixed-rate mortgage: Which one is right for you?
You may want an ARM if:
- This is not a long term home. If you don’t think you’ll last long, you can take advantage of your low initial interest rate and sell your home before the rate goes up.
- You expect to earn more. A variable interest rate is best for borrowers who are financially comfortable managing rising costs. If you expect your income to rise in the next few years, your bank account may carry an ARM. Along with this, if you have a higher income now, you can make extra payments on your loan and pay it off earlier – before the new interest rate kicks in. But make sure this is okay with your lender, so you don’t incur a prepayment penalty.
You may want a fixed-rate mortgage instead:
- You are buying your forever home. For borrowers considering a home purchase that you plan to keep for the long term, a variable interest rate may not be your best option. If your goal is to live in your home for many years, a fixed-rate mortgage may be better for you because it is reliable and consistent.
- You have a tight budget. Fixed loans mean you’re paying the same amount every month, so you know exactly what you’re responsible for. If your budget is tight, ARMs may be too much for your money, even if the conversion is a few years down the road.
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