If you’re looking for a new home, you’ve probably heard the term adjustable-rate mortgage thrown around (otherwise known as an ARM).
But what exactly does it mean? And how is an adjustable rate mortgage different from a traditional fixed-rate mortgage?
We have you covered. Peregrine Financial is a successful mortgage brokerage in Santa Clarita, and we're breaking down the details of an adjustable-rate mortgage, how it works, its benefits, and what to consider before getting one.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can change periodically. Unlike a fixed-rate mortgage, where the interest rate remains the same for the entire term of the loan, an ARM typically starts with a lower introductory fixed rate period, and then adjusts at predetermined intervals based on market conditions.
How Does an Adjustable-Rate Mortgage Work?
ARMs follow a structure that includes an initial fixed interest rate period, adjustment periods, and an index plus margin formula to determine future rates.
So what does that mean?
Initial Fixed-Rate Period - Most ARMs begin with the same interest rate for a set number of years, commonly 3, 5, 7, or 10 years. During this time, your mortgage's monthly payment remains stable, often at a lower rate compared to fixed-rate mortgages.
Adjustment Period - Once the fixed initial period ends, the interest rate can adjust at regular intervals, typically annually. ARM interest rates change based on a financial index, such as the U.S. Treasury rate or the Secured Overnight Financing Rate (SOFR), plus a lender-determined margin. This can change your monthly mortgage payment.
Rate Caps - To prevent excessive payment increases, ARMs include rate caps that limit how much the interest rate can change at each adjustment period - and over the life of the loan. These include:
Initial Adjustment Cap: Limits the first rate increase after the fixed period.
Periodic Adjustment Cap: Restricts how many percentage points the rate can change at each adjustment.
Lifetime Cap: Establishes a maximum increase over the life of the loan.
Benefits of an Adjustable-Rate Mortgage
Lower Initial Interest Rate:
ARMs typically offer lower starting interest rates compared to fixed-rate loans, resulting in lower monthly payments during the initial years.
Potential for Lower Long-Term Costs:
If interest rates remain stable or decrease, borrowers could pay less interest over time compared to a fixed-rate mortgage.
Flexibility for Short-Term Homeowners:
ARMs can be a great choice for buyers who plan to sell or refinance before the adjustable period begins.
Qualification for a Larger Loan:
The lower initial payments may help borrowers qualify for a higher loan amount.
Risks and Considerations
Rate Increases: Once the fixed period ends, monthly payments could increase significantly depending on market interest rates.
Payment Uncertainty: Unlike fixed-rate mortgages, ARMs don’t offer long-term payment stability, making budgeting more challenging.
Complexity: ARMs can be more difficult to understand than traditional loans, requiring borrowers to carefully review loan terms.
Refinancing Costs: If rates rise and a borrower wants to refinance into a fixed-rate mortgage, they may incur additional costs.
Who Should Consider an ARM?
An adjustable-rate mortgage can be a great option for certain homebuyers, who:
Plan to sell or refinance within a few years.
Want lower initial payments to improve cash flow.
Are comfortable with some level of risk and rate fluctuation.
Believe the Federal Reserve Bank interest rates will stay the same, or decrease, over time.
How to Choose the Right Adjustable Rate Mortgage
When selecting an ARM, look at:
Length of the Fixed Period: The longer the introductory-rate period, the more stability you’ll have before adjustments begin.
Index and Margin: Understand which index your loan is tied to and how the margin affects rate adjustments.
Rate Caps: Make sure you know the maximum potential rate increase to avoid payment shock.
Future Plans: Consider your long-term housing goals and whether an ARM aligns with them.
The Best Adjustable Rate Mortgage Broker
An adjustable-rate mortgage can be a smart financial tool for certain homebuyers. If you’re not sure whether an ARM is right for you, contact our team at Peregrine Financial. We have a proven track record of success in getting clients the loans that fit their needs best.
If you have questions about ARMs or want to explore mortgage options, reach out today.
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