Adjustable Rate Mortgages
Adjustable Rate Mortgages Defined
Adjustable Rate Mortgages (often called ARMs) feature a variable interest rate; the monthly payment can increase or decrease depending on changes in the interest rates.
- Typical length of loan term is 15 or 30 years.
- The interest rate on the loan may go up or down.
- Monthly payments can increase or decrease.
Reasons to Consider an Adjustable Rate Mortgage:
- You plan to stay in your home or keep your mortgage for less than 5 years.
- You accept that monthly payments will likely change periodically.
- You are comfortable with the risk of possible payment increases in the future in exchange for potentially lower monthly payments in the near term.
- You think your income will probably increase in the future.
Key Advantages of ARMs:
- The initial interest rate on these loans is typically lower than a fixed rate mortgage. That means monthly payments are also lower.
- The lower monthly payments make it easier to get approved for an ARM for the same loan amount compared with a fixed rate mortgage.
- You may be able to borrow higher amounts. This may be good news if you are:
- Moving up to a more expensive home.
- Looking for a way to consolidate debt.
- Planning on making an investment for which you need cash now.
Key Disadvantages of ARMs:
- Your interest rate moves with market rates, which is an obvious benefit when rates are falling, but during rising rate markets, you need to pay closer attention to an ARM.
- Paying less than the amortized payment each month will result in future payments being higher, or potentially much higher.
- After the introductory period, the interest accrual rate will likely begin to adjust to the fully-indexed rate. If the interest accrual rate rises, then your minimum monthly payment may not be enough to pay all the interest you owe on the loan.
How much change in interest rates should you expect?
There is no accurate method to predict interest rate changes. The interest rate on an ARM is determined by combining an interest rate index which is published and not controlled by the lender, plus a small margin.
Periodic interest rate changes are great if interest rates go down, but conversely it also means your payments will increase if rates go up. But what if interest rates increase sharply? The majority of ARMs have rate caps for your protection, which constitutes an amount which the loan’s interest rate may never exceed for the life of the loan. ARMs without a cap are not a good idea. In fact, if your lender does not offer a rate cap it’s probably a good idea to look for another lender.
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