Adjustable-rate mortgages are home loans with an interest rate that changes over time. This type of home loan can be risky, but with a lower initial interest rate than fixed-rate mortgages, 5/1 ARMs can be a good option – especially if you plan to sell or refinance within a few years, before the lower interest rate adjusts.
Some prospective homebuyers may be considering an ARM as an alternative to a traditional fixed-rate mortgage in the current rate environment. In May 2022, the Mortgage Bankers Association reported that demand for ARMs reached a 14-year high this spring, as 30-year fixed rates surged beyond 5%.
“More borrowers continue to utilize ARMs to combat higher rates,” says Joel Kan, the group’s associate vice president of economic and industry forecasting, in a release.
That being said, there are a few things you should know about using an ARM to finance your home purchase. This guide can help you understand adjustable-rate mortgages and find the right lender for your homebuying needs.
- What is an adjustable-rate mortgage?
- How do adjustable-rate mortgages work?
- When does an adjustable-rate mortgage make sense?
- How can you choose the best adjustable-rate mortgage lender?
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Axos Bank, founded in 2000, is a digital financial services company based in San Diego. The full-service online bank offers everything from personal and business savings and checking accounts to auto and home loans.
Borrowers with an Axos Bank checking account can reduce or eliminate the lender fee and earn cash back by using the account to make monthly mortgage payments.
AmeriSave Mortgage Corp. is an online lender that has been in business since 2002. It was one of the first to offer an offsite, digital mortgage experience for customers. The company says it has financed more than 390,000 homes since it began operating. With headquarters in Atlanta, AmeriSave services loans in 49 states and Washington, D.C.
Caliber Home Loans of Coppell, Texas, offers mortgage products nationwide. Options include conventional, adjustable-rate, jumbo, refinancing, Federal Housing Administration, U.S. Department of Agriculture and Department of Veterans Affairs loans.
Caliber has been in business since 2008, and is solely focused on home lending products.
Carrington Mortgage Services, founded in 2007, offers an array of mortgage and refinancing options to borrowers seeking conventional or government-backed loans. Its California-based parent company, Carrington Holding Co., was established in 2003 and provides a range of real estate services. Carrington Mortgage Services is based in California and also has offices in Arizona, Connecticut, Florida, Indiana and Maryland.
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What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage is a home loan with an interest rate that changes over time. Unlike with a fixed-rate mortgage, which keeps the same interest rate for the life of the loan, your interest rate will change according to a benchmark rate.
The three most common types of ARMs are hybrid, interest-only and payment-option.
- A hybrid ARM is the most common type of adjustable-rate mortgage. It has an initial interest rate that remains fixed for a certain amount of time and then adjusts periodically afterward. So a 5/1 adjustable-rate mortgage has one rate for the first five years and, after that, adjusts every year. A 3/1, 7/1 or 10/1 ARM works the same way, adjusting annually after the initial fixed-rate period (three, seven or 10 years, respectively). However, if the second number is six, such as a 7/6, your rate may adjust every six months after the initial fixed period.
- An interest-only ARM is an adjustable-rate mortgage that only requires interest payments during the initial payment period. Since there are no principal payments during the initial payment period, the loan balance does not go down. At the end of the initial payment period, the loan is amortized based on the remaining term, and the required monthly mortgage payment increases substantially.
A payment-option ARM is an adjustable-rate mortgage in which the borrower can choose from multiple payment options. Usually, the options are:
- Standard principal and interest payment. The loan balance goes down with each payment.
- Interest-only payment. The loan balance remains the same with each payment.
- Limited payment. The loan balance increases with each payment.
If you make a payment that does not cover the interest, the unpaid interest is added to the loan balance and amortized. Payment-option ARMs are recalculated at predetermined intervals, such as every five years, or if the loan balance reaches a preset limit, such as 125% of the original loan balance. After recalculating the loan, the lender will set a required monthly payment to guarantee you will pay off the loan by the end of the remaining loan term.
With a convertible ARM feature, you can pay a conversion fee upfront so that the loan can be converted to a fixed-rate mortgage after a period of time. For this product, the initial interest rate may be a little higher than the rate on a nonconvertible ARM. The rate at conversion will be based on current mortgage rates and may be higher than the rate available for a new fixed-rate mortgage.
Adjustable-rate mortgages are available from home loan programs through the Federal Housing Administration, U.S. Department of Veterans Affairs and U.S. Department of Agriculture as well as for conventional and jumbo loans.
Typical loan terms are 15 and 30 years, but 10- and 20-year terms are also common.
An adjustable-rate mortgage is like any other mortgage: A lender pays a seller for the home you want to buy, and you make regular monthly mortgage payments to the lender until the loan is paid off. But unlike with a traditional fixed-rate mortgage, the interest rate changes periodically, per the terms in the loan contract.
Most adjustable-rate mortgages start with a competitive initial fixed-rate period, often with a lower interest rate than what’s available on fixed-rate mortgages. When the period ends, the interest rate changes at predetermined intervals, according to the benchmark rate the loan follows.
An ARM interest rate can be based on a major index rate – such as the one-year Treasury constant maturity rate; the 11th District Cost of Funds Index, or COFI; or the London Interbank Offered Rate, or Libor – or it may be the lender’s own cost of funds index. The lender chooses its own index, then adds a margin to the benchmark rate to calculate your interest rate.
Your interest rate changes when your adjustment period ends. The lender can raise your rate if its fully indexed rate is higher than your current mortgage rate. If the benchmark rate goes down, the lender might lower its fully indexed rate and, accordingly, your rate.
Caps set the boundaries on how much your interest rate can change. An interest-rate cap can be periodic, limiting how much the rate can rise at each readjustment period, or lifetime, restricting your interest rate for the life of the loan. Nearly all adjustable-rate mortgages are required to have a lifetime cap.
For example, if your initial rate is 4% with a 2% periodic rate cap and the fully indexed rate is 7% at the time of your recast, your rate will only rise to 6%.
Payment caps limit the amount your monthly payment can increase, regardless of how much the benchmark rate increases. While it keeps your monthly payment amount in check, it doesn’t stop interest from building. Any unpaid interest will be added to your outstanding loan balance.
It’s important that borrowers examine their individual situations and decide whether or not an ARM is the best fit.
ARMS Can Be a Great Choice
An adjustable-rate mortgage offers a competitively low interest rate for those who can avoid or minimize the impact of a potentially rising rate in the future.
“A major question is the borrower’s time horizon,” says Jack Guttentag, author of The Mortgage Professor blog. If you plan to sell the property or refinance before the first adjustment period or before future interest charges outweigh early interest savings, you could save money.
“Another circumstance in which an ARM might be preferable, even when the time horizon is indefinite,” says Guttentag, “would be where the monthly payment difference is very important now, but in the future the borrower expects her income to increase significantly.”
An ARM can be a good option for first-time homebuyers who plan to refinance or sell their home or expect an income boost in a few years. For example, a military family on limited deployment or a medical student who will become a doctor might be a candidate for an ARM.
ARM Loans Are Not for Everyone
However, an ARM is not the best choice for every borrower because of the potential for rate increases over time. ARMs can be complex and terms can be difficult to understand, so borrowers should be fully familiar with their benefits and drawbacks before moving forward.
You may be surprised at how much the payment can increase in the future or at the challenges you could face in selling or refinancing the property. There are several ways to achieve negative amortization on an ARM, resulting in a loan balance larger than what you originally borrowed.
“Taking an ARM now with the goal of refinancing at the end of the first adjustment period can be complicated,” says Matthew Ribe, senior director of legislative affairs and corporate secretary for the National Foundation for Credit Counseling.
One selling point of ARMs is that, technically, the rate could go down. But because an ARM tends to start low, increases are typically inevitable, especially for loans that originate in an already-low-interest market. In some loans, the rate is not allowed to drop below a predetermined minimum, even if the benchmark rate goes lower.
Before considering an ARM, keep in mind that you can’t get something for nothing. Banks make ARM loans because they believe loan rates will rise enough to offset your savings in those initial years. The unpredictability of an ARM makes it inherently riskier than fixed-rate mortgages, and that risk is your trade-off for favorable starting terms.
Your home loan’s interest rate influences your monthly payment and how much the loan costs over time. The lower your interest rate, the lower your monthly mortgage payment and overall cost of borrowing, so it pays to shop around for the lowest mortgage rate you can get.
Many factors influence mortgage interest rates, including benchmark rates, borrower demand and your credit score. Take these steps to get the lowest mortgage rate possible:
- Examine your credit history and finances.
- Choose the right loan and rate type.
- Compare mortgage rates with multiple lenders.
Advertised rates are best-case scenarios, offered to borrowers with the strongest applications. Your credit score, size of down payment and debt-to-income ratio (how much of your gross income goes to debt payments) have a major influence on the loan rates you’re offered. Before you start rate shopping, check your credit history for errors and identify areas to improve.
Loan rates vary based on loan type and terms. For example, the interest rate for a 30-year fixed-rate mortgage isn’t likely to be the same as a 30-year ARM. Look into current mortgage rates for different programs to see which offers the best rate, as these can fluctuate depending on demand.
Compare mortgage rates with a few lenders so you can select the one that offers the lowest mortgage rate. You can do this by prequalifying, which requires a soft credit pull that doesn’t affect your credit score.
Keep in mind that some lenders only offer mortgage preapproval, which requires a hard credit check that will have a temporary negative impact on your credit score. If you decide to shop across lenders, keep your applications within a 45-day window. That way, multiple hard inquiries will be counted as a single inquiry, allowing you to minimize ding to your credit score.
As you research loan options, you may find that a loan with a low interest rate can keep you under the debt-to-income ratio limit set by the lender.
“The lender uses this initial interest rate to decide whether you have enough income to qualify for the mortgage, even though the rate usually rises at the end of the initial adjustment period,” says Guttentag. That could translate to an unaffordable monthly mortgage payment if your income does not rise.
The four key factors for choosing the best adjustable-rate mortgage lender are:
Product offerings. The best lender will offer products with the terms and features that meet your needs, whether that be conventional, FHA or VA loans.
Interest rates. A low interest rate can save you tens of thousands of dollars over the life of your loan. Even a fraction of a percent can drive significant savings – or costs. Compare mortgage rates from multiple lenders to find the best deal.
You might want to discuss the pros and cons of various ARM options with the lender, including:
- 5/1 ARMs
- 7/1 ARMs
- 10/1 ARMs
- Interest-only ARMs
Closing costs. Lenders have some flexibility when it comes to many closing costs. For example, some, but not all, charge an origination fee. Generally, lower upfront costs are associated with higher interest rates. If you are looking for a loan with as little out-of-pocket cost as possible, you may face higher costs overall and vice versa.
Customer service. As with any major purchase, find out what other customers say. You may be tied to this lender for years or decades, so choose one that has demonstrated an ability to provide good customer service.
LoanDepot is a mortgage lender that operates nationally with more than 200 branches and delivers both a digital experience and face-to-face service. The lender offers fixed- and adjustable-rate conventional mortgages, Federal Housing Administration and Department of Veterans Affairs loans, as well as refinance and renovation loans. The company was founded in 2010 and is based in Foothill Ranch, California.
Pentagon Federal Credit Union, widely known as PenFed, offers borrowers access to many types of mortgages: conventional, adjustable rate, jumbo and Department of Veterans Affairs, plus refinancing loans and home equity lines of credit. The financial institution, which serves 2.5 million members, was established in 1935 and is based in McLean, Virginia.
Flagstar offers banking and loan products to borrowers in all 50 states. Borrowers can obtain mortgage and home equity products including conventional loans, Federal Housing Administration loans, Veterans Affairs loans, U.S. Department of Agriculture loans, adjustable-rate mortgages, and home equity loans and lines of credit.
North American Savings Bank, or NASB, is a Missouri-based bank and lender founded in 1927 that offers home mortgages nationally. NASB provides a variety of mortgage options, including conventional, Federal Housing Administration and Department of Veterans Affairs loans, and products for borrowers who might otherwise have trouble getting a mortgage.
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