Adjustable Rate Mortgage

When it comes to mortgages, borrowers can choose between a fixed-rate mortgage or an adjustable-rate mortgage [ARM]. Adjustable-rate mortgages are one of the most common types of mortgage loan options today.

In this article, we discuss everything you need to know about adjustable-rate mortgages. Let’s get started.

An adjustable-rate mortgage, or ARM, is a type of home loan with a varied interest rate. This means that the monthly payments can go up or down. With this type of home loan, the initial rate is fixed for a certain period of time. After that period expires, interest rates and your monthly payments may reset periodically, at monthly or yearly intervals.

As already mentioned, an adjustable-rate mortgage is a home loan with an interest rate that can change periodically. But for a fixed-rate mortgage, it is a type of mortgage with a fixed interest rate that doesn’t change throughout the life of the loan.

Adjustable-rate mortgages are generally more complicated than a fixed-rate mortgage. The fixed-rate mortgages make it typically easier for homeowners to budget, though this is not the case with an adjustable-rate mortgage because the monthly payments can change frequently.

Before you choose either of the two types of mortgages, there are things you need to put into consideration. For instance, if you are considering an ARM, you need to run the numbers to determine the worst scenario. But an ARM can save you money in the long run if you can afford it, even if the mortgage resets to the maximum cap in the future.

1. Lower initial interest rate, which translates to lower monthly payments 
2. Interest rate and monthly payments might decrease
3. The interest rate cannot rise beyond the cap limit
4. They offer greater flexibility

1. Your monthly payments and interest rate could increase 
2. Its structure is more complex to understand
3. Potential for a prepayment penalty
4. Not easy to budget because of the varying monthly payments and interest rates
5. Things may not go as planned

With an adjustable-rate mortgage, borrowers risk paying higher monthly payments once the initial period ends. At that point, the interest rate will change at certain intervals, usually every six months to a year. The new rate will be based on the market rate, which might be higher than the initial rate. This can really cause hardship on the borrower’s part if they cannot afford to make the new payments. This is referred to as payment shock. It’s best to stay on top of interest rates as your adjustment period approaches to prevent the payment shock.

Yes, it is possible to refinance an adjustable-rate mortgage. In fact, the process is as simple as refinancing any other type of loan. When refinancing ARM, you essentially replace your existing loan with a new updated loan. When you opt to refinance your ARM, you simply take out another loan that you use to pay off your original mortgage. You don’t have to go through the same lender; you can look for another one.

There are things you need to keep in mind, when considering refinancing your adjustable-rate mortgage, including:

• Length of ownership, which should typically be at least six months
• Home equity, which should be 20% or more
• Good credit score
• Debt-to-income [DTO] ratio, usually under 50%

A rate cap: This is the most your monthly payment or interest rate can increase. It should be disclosed to you upfront. The rate cap usually comes in two forms: periodic caps and lifetime caps. The periodic caps limit how much the borrower’s interest rate can increase from one period to the next, while a lifetime cap puts a lid on how much the borrower’s rate can go up over the life of the loan.

To calculate an ARM once it goes adjustable, add the preset margin and the current index price, and then multiply it by the outstanding loan amount. For instance, if you took out a 5/1 ARM [the first adjustment in five years, then adjusts annually] with a rate of 2.5% and a loan amount of $200,000, the monthly payment would be $790.24 for the first 60 months.