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Adjustable-Rate Mortgages Vs. Fixed-Rate Mortgages
Everyone wants a low interest rate.
Some interest rates, though, seem too good to be true.
If you're skeptical about certain advertised interest rates, it's smart to follow through on your gut feeling and dig deeper into the terms of the loan. You might find that those low interest rate loans are adjustable-rate mortgages.
The reality is adjustable-rate mortgages (ARMs) are not inherently bad. They have their pros and cons, so how do you know which type of loan is right for you?
Related: 5 Rookie Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
Compare ARMs side-by-side with fixed-rate mortgages and use our ARM Mortgage Calculator. Quickly discover the maximum monthly payment, total interest, and more information for each type of mortgage.
Below is more information about adjustable-rate mortgages so that you can make the best choice for your financial situation . . . .
What Is An Adjustable-Rate Mortgage?
An adjustable rate mortgage is a mortgage where the interest rate rises and falls to reflect market conditions. They are designed to transfer the interest rate risk from the lender to the borrower.
If market interest rates (the cost to the lender when borrowing in the credit markets) change, the lender will pass that interest rate change on to all their adjustable rate mortgage holders at predetermined intervals (usually once per year) by a pre-approved percentage.
ARMs have several unique features that are important to understand:
- An initial interest rate – This is the interest rate at the beginning of the ARM, which is typically lower than market interest rates (known as a teaser rate) and also lower than competing fixed-rate mortgages.
- A margin – This is a number of percentage points that the lender adds to the index rate which will result in the adjustable-rate mortgage's interest rate.
- An index rate – Many lenders base ARM interest rates on an index, commonly LIBOR or U.S. Treasury securities.
- Interest rate caps – Thankfully, there are limits on how high ARM interest rates can rise each year and over the life of the loan.
- An adjustment period – This is a period of time when the interest rate remains unchanged before the next adjustment is allowed.
Additionally, ARMs can have special conditions such as initial discounts, negative amortization when mortgage payments are too small and there's not enough money to pay the interest at the beginning of the loan, future conversion to fixed-rate mortgage requirements, or prepayment requirements.
Some of these features can be desirable, but not all. Let's take a closer look at more specific adjustable-rate mortgage pros and cons.
Adjustable-Rate Mortgage Pros And Cons
Adjustable-rate mortgages have their share of advantages and disadvantages. Consider the following:
- Lower initial interest rates compared to fixed-rate mortgages – Lower rates means lower payments which will give you the opportunity to increase your savings.
- There’s a possibility that interest rates can drop further – The interest rate depends on market performance, so if market rates fall, your interest rate will also drop. It's more likely to happen if you start your adjustable-rate mortgage when interest rates are high.
- If you don’t have plans to stay in your house for a long time, then an ARM might work out best – There is usually a fixed number of years at the initial low interest rate meaning you you can save money using this type of loan if you sell your home before the interest rate adjusts.
- Adjustable-rate mortgages have interest rate caps, which limits both how quickly the interest rate can rise and how far it can go up – This allows you to calculate the “worst-case scenario” using the ARM Mortgage Calculator.
- Monthly payments can increase when market interest rates rise – Most home buyers worry about ARMs when interest rates are very low because the perceived risk is that interest rates can only rise. The result would be increasing payments that can wreak havoc with your household budget.
- Beware of special loan terms – Most ARMs are pretty straightforward but some have conversion or prepayment requirements that can significantly impact the total cost of the loan. Make sure you read the fine print.
- The first interest rate adjustment might not be limited by the cap – This can be particularly dangerous because your payment can not only rise, but it can rise dramatically in a single adjustment possibly becoming unaffordable.
- Adjustable-rate mortgages can cause stress – Stated simply, adjustable rate mortgages are riskier because the interest rate risk has been transferred from the lender to you. Your payment is no longer fixed and you can't budget. This uncertainty can be stressful for some homeowners.
Adjustable-rate mortgages aren't necessarily bad, but they have specific characteristics that make them only appropriate under certain conditions. They are not for everyone. Before making a decision, it is important to do your research and compare loan options so you can make a fully informed decision.
Just like any other long-term loan, plan for the future. If you are looking at living in the home for a short period of time, an adjustable-rate mortgage may be the best option for you. But if you are planning to live in the home for a longer period of time, you may be better off with a fixed-rate mortgage.
Use this ARM Mortgage Calculator to begin your research process today!
ARM Mortgage Calculator Terms & Definitions
- Mortgage – The charging of real (or personal) property by a debtor to a creditor as security for a debt on the condition that it shall be returned on payment of the debt within a certain period.
- Adjustable-Rate Mortgage (ARM) – A mortgage whose interest rate is adjusted periodically to reflect market conditions.
- Initial Interest Rate – Sometimes known as the teaser rate, it is the first interest rate charged on the mortgage. (On an adjustable-rate mortgage, this rate may be for as long as five years or as short as one month depending on the loan terms.)
- Margin – This is a number of percentage points that the lender adds to the index rate which will result in the adjustable-rate mortgage's interest rate.
- Indexed Rate – An standardized, benchmark interest rate (usually LIBOR or U.S. Treasury Securities) used as the basis for the mortgage interest rate calculation by taking the sum of a benchmark index interest rate and adding a specified margin. The indexed rate is used to calculate the interest rate on an adjustable-rate mortgage (ARM).
- Adjustment Period – The period that elapses between the adjustment dates for an adjustable-rate mortgage.
- Fixed-Rate Mortgage – A mortgage whose interest rate does not adjust during the loan term.
- Maximum Adjustment – The highest amount an interest rate can adjust per year.
- Loan Term – Period over which a loan agreement is in force.
- Interest Rate – An interest rate is the rate at which interest is paid by a borrower for the use of money borrowed from a lender.
- Fixed Interest Rate – The interest rate of the fixed-rate mortgage which will remain the same over the loan term.
- Interest Rate Cap – The interest rate limit set for adjustable-rate mortgages (can also refer to the annual increase or decrease limits).
- Interest – Money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt.
- Principal – Denoting an original sum lent or remaining balance on a mortgage.
- Refinance – Financing something – like a mortgage – again, typically with a new loan at a lower rate of interest.
- Amortization – The spreading of payments over multiple periods resulting in the loan being fully repaid, both principal and interest, at the end of the loan term.
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