ARM
Unlike a fixed rate loan where the interest rate doesn’t fluctuate, with a variable or an adjustable-rate mortgage (ARM) the interest rate changes over a preset term. These loans are designed to offer an initial interest rate for a predetermined time period and then adjust at preset intervals for the remainder of the loan. These intervals can be set at any length of time, but a one-year interval is the most common.
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Pros and Cons of an Adjustable-Rate
There are several benefits with an adjustable-rate mortgage. At the beginning of the loan introductory interest rates are typically lower than they would be with a fixed-rate loan, so the initial monthly loan payments are smaller. This gives the borrower an opportunity to put more money towards the principal of the loan and to build up equity faster. Additionally, if interest rates drop, the borrower gets the benefit of a lower rate without refinancing the loan.
There are risks involved with this type of loan as well, the most apparent being that a variable interest rate is subject to change. If you have secured a low introductory rate, it is likely to increase after the first term of the loan. When the interest rate increases, the monthly loan payments increase as well without any additional money going towards the principal of the loan. This loan also makes long term planning more difficult, since it isn’t possible to know ahead of time what the next interval interest rate will be.
Understanding Caps on an ARM
If you are considering an adjusted-rate mortgage loan, it is important to make sure there is a cap, or maximum amount the interest rate can increase. Here are some of the most common caps:
- Lifetime cap: this limits how much the interest rate can increase over the life of the loan.
- Payment cap: this limits the dollar amount that the monthly payment can increase over the life of the loan.
- Periodic rate cap: this limits how much the rate can change at one time and prevents your interest rate from rising more than the capped amount each year.
The Ideal Candidate for an Adjustable-Rate Mortgage
An adjustable-rate mortgage is a good option for a homebuyer who plans to take on a shorter-term loan, or a buyer who plans to sell the house shortly after purchasing it. This type of loan could be also appealing to a buyer who plans to fix and flip a house and is confident that they can sell the property before interest rates adjust. A fixed rate loan is also worth considering when interest rates are higher than historic averages since these loans are often are sold below market rate.