Understanding Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages (ARMs) offer the potential to save money on interest rates, especially in the short to medium term. However, when it’s time for the interest rate to reset, borrowers may face increased monthly mortgage payments. This could be challenging for many individuals, considering the typical American budget constraints.
What Is an Adjustable Rate Mortgage (ARM)?
In order to grasp the concept of an adjustable-rate mortgage, it is essential to understand how it functions. With an ARM, borrowers secure an interest rate, often a low one, for a predetermined period. Once this period concludes, the mortgage interest rate adjusts to the prevailing rate.
The initial fixed period for an ARM can vary from six months to ten years. Some ARM products may see a substantial increase in interest rates and monthly payments later in the loan term.
ARMs appeal to borrowers due to their initially low interest rates, particularly beneficial for those not planning to remain in their homes for an extended period or who are prepared to refinance should interest rates rise. However, interest rate adjustments, influenced by Federal Reserve actions, can impact monthly payments.
While adjustable-rate mortgages received negative attention during the financial crisis, they can be a suitable option if borrowers understand the implications of interest rate adjustments.
Know the Adjustment Period
In assessing the suitability of an ARM, understanding the adjustment period is crucial. This period refers to the time between interest rate changes.
For instance, a one-year ARM would have the interest rate adjusted annually, leading to changes in monthly mortgage payments. Similarly, a three-year ARM would see rate adjustments every three years. Hybrid products like the 5/1 ARM offer fixed rates for the first five years, followed by annual rate adjustments.
The Basis for the Rate Change
Lenders determine ARM rates based on various indexes, such as one-year constant maturity Treasury securities, Cost of Funds Index, and the prime rate. Prior to opting for an ARM, it is essential to ascertain the index utilized and its historical fluctuations.
Avoid Payment Shock
One of the risks associated with ARM adjustments is payment shock, where significantly higher monthly mortgage payments strain the borrower’s finances. To circumvent this, borrowers should monitor interest rates as the adjustment period nears.
According to the Consumer Financial Protection Board (CFPB), mortgage servicers must provide an estimate of the new payment well in advance to allow borrowers time to plan accordingly. Exploring available options and seeking assistance from housing counselors can help manage potential payment increases.
How Do Adjustable-Rate Mortgages Work?
Adjustable-rate mortgages involve changing interest rates over time, unlike fixed-rate mortgages with steady rates throughout the loan term. ARMs usually start with low introductory rates before adjustments occur based on economic factors and loan terms.
What Are the Benefits of Adjustable-Rate Mortgages?
Initial low rates make ARMs appealing for short-term property ownership or for individuals waiting to assess market movements before refinancing. If market rates decrease, ARMs could offer lower rates in the future, though the opposite is also true.
What Does It Mean to Have a 5/1 Adjustable-Rate Mortgage?
A 5/1 ARM involves a fixed interest rate for the first five years, shifting to an adjustable rate thereafter for the remaining loan duration.
The Bottom Line
While adjustable-rate mortgages pose risks, understanding the implications of rate adjustments can make them a viable choice. Unlike fixed-rate mortgages, ARMs undergo interest rate changes, potentially leading to increased payments. Planning ahead and being aware of potential payment adjustments can help borrowers manage their mortgage obligations effectively.