Adjustable-rate Mortgages: Everything You Need To Know

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Adjustable-rate mortgages: Everything you need to know

Adjustable-rate mortgages: Everything you need to know

The vast majority of mortgages are of the traditional, fixed-rate variety which offer stability and predictable payments for the life of your loan. Adjustable-rate mortgages offer more flexibility -- and often a lower initial rate -- than fixed-rate loans. But you're going to take on some risk in exchange for those benefits.

Low rates on fixed-rate mortgages may have driven more borrowers away from ARMs over the past decade -- they currently make up a tiny share of the overall mortgage origination market -- but they can still be a good choice in the right circumstances, according to Mike Swaleh, area manager with Fairway Independent Mortgage Company in St. Louis.

"You really only want to take on the risk of an ARM product when the rate difference compared to a fixed-rate loan is high enough to make it worth it," says Swaleh. ARMs can also be a good idea if you're not planning on owning the home for longer than the introductory period or you have the financial flexibility to withstand a high rate increase.

Below, we break down how ARMs work, how they differ from other types of mortgages and whether they're a good option for you.

What are adjustable-rate mortgages?

There are many types of ARMs, but they all have one thing in common: a fixed-rate introductory period followed by a variable interest rate. This is what differentiates all ARM products from traditional fixed-rate mortgages.

With an ARM, you'll pay a set rate for an introductory period of one or more years (more on that below), after which the interest rate can go up or down -- depending on a range of macro-economic factors. Once you're in the adjustable-rate period, your monthly payment could change significantly every year -- making budgeting more difficult.

The big appeal of ARMs is that the initial introductory rate is usually lower than the rate on a fixed-rate mortgage. This has held true even in 2021, when fixed rates have hit historic lows. With an adjustable-rate mortgage, you're taking a gamble that the savings you collect in that introductory period will pay off even if your payment eventually goes up.

Two factors that will affect your payment during the adjustable-rate period are indexes and caps.

Indexes that affect ARMs

Short-term rates like those for ARMs are based on a few major indexes. These indexes set the base rate for any loans that are made. The most common ones for ARMs are:

The Constant Maturity Treasury: This is the weekly average yield on the US Treasury note, which represents short-term government securities and is backed by the Federal Reserve Board.
Secured Overnight Funding Rate: This rate, which serves as a benchmark for all overnight cash lending, is replacing the London Interbank Offered Rate as the primary index for short-term loans.
The 11th District Cost of Funds Index: This provides a weighted average of the rates banks pay on savings accounts and money they borrow from other institutions.

On top of whichever index your ARM uses, your lending institution will set a margin. This margin is usually set for the life of your loan and added to your current rate when your loan adjusts. For instance, if the index is 1.5% and your lender's margin is 2%, your effective rate is 3.5%.

Adjustable-rate caps

These indexes can change significantly over time, which leaves you vulnerable to substantial rate swings. This risk is somewhat mitigated, however, by rate caps. These caps serve as guard rails that prevent your interest rate and loan payment from increasing too much.

Your adjustable-rate loan caps should be disclosed upfront and usually come in one of two forms:

Periodic caps, which limit how much your rate can increase from one period to the next.
Lifetime caps, which put a lid on how much your rate can go up over the life of the loan.

Although payment caps protect you from big rate hikes, they can also expose you to something dangerous: negative amortization. If the index rate is higher than your cap, your payment might not be large enough to cover the principal, and you could end up seeing your loan balance go up instead of down.

How introductory periods work

To truly understand adjustable-rate mortgages, it's important to get a handle on the nomenclature.

With a 5/1 ARM, the five indicates your introductory period -- five years -- and the second number -- the one -- indicates the annual frequency with which your rate readjusts after the introductory period ends. For a 5/1 ARM with an introductory rate of 2.5% (0.5% index and 2% margin) and a 30-year term, your rate will be set at 2.5% for the first five years, after which it's eligible for adjustment once a year.

This means that you can count on a set payment for five years. In year six, if the index jumps to 2.5%, your new effective rate is 4.5%. For the remaining 25 years of your loan, your principal payment won't change, but your interest payment will increase. And that could add hundreds of dollars to your monthly payment.

Common types of adjustable-rate mortgages

There are a wide variety of ARMs on the market. Here's an overview of the most common ones:

Hybrid ARMs

These ARMs have both a fixed period and an adjustable period, as indicated in the example above. The first number indicates the fixed period (in years), and the second indicates how often the adjustable rate will be reviewed and updated. This adjustment time frame is usually one year but could be different (every six months or every five years, for example). Common types of hybrid ARMs include:

5/1 ARM: The most common ARM, this mortgage features an introductory five-year fixed-rate period after which your rate can be adjusted annually.
7/1 ARM: This ARM has a seven-year fixed-rate introductory period, after which your adjustable-rate would change once a year for the duration of the loan.
10/1 ARM: This ARM has a 10-year fixed-rate introductory period, after which your adjustable-rate could change once a year for the duration of the loan.
One-year ARM: This ARM has a one-year fixed-rate introductory period, after which your rate would adjust once a year for the duration of the loan. Right now, one-year ARMs are popular options for jumbo loans, particularly since current rates are at all-time lows.

Interest-only ARMs

These ARMs offer an introductory period during which you pay only interest while your principal balance stays the same. Often, you'll have a low monthly payment during the introductory period, but it could increase significantly once you're required to start paying off the principal -- especially if your rate increases at the same time.

Payment-option ARMs

These adjustable-rate mortgages offer considerable flexibility -- and risk. Lenders may offer several payment options, including paying interest and principal, only paying interest or making a minimum payment -- each with its own pros and cons. Some lenders may let you select a different payment option each month. Unpaid interest on these types of loans can add up quickly, however, putting you at risk of negative amortization.

FHA ARM Loans

You don't need a conventional loan to opt for an ARM. FHA loans, which are backed by the Federal Housing Administration, are also available in various hybrid formats. These loans are typically used for first-time homebuyers and can be a good option if you can't afford a 20% down payment or have poor credit. FHA ARMs are available as one-year ARMs, as well as 3/1, 5/1, 7/1 and 10/1 options.

Reasons to consider an adjustable-rate mortgage

Despite the risks, an ARM can be a good option for some home buyers. They offer several advantages:

Lower interest rates than fixed-rate mortgages: The difference varies based on market conditions, but you're likely to get a lower initial rate on an ARM than a 30-year, fixed-rate mortgage. When fixed rates are high, ARMs can make for a compelling alternative.
Flexibility: If you know you're not going to be in a home for the long haul, you can take advantage of a low introductory rate and then refinance or sell before you reach the adjustment period.
Low introductory payments: Locking in a low monthly payment for five years (or more) can free up funds for other purposes. And if you expect to earn a higher salary in the future, a higher monthly payment in the future may be less daunting.
Rates and monthly payments may decrease: There's always the chance that your rate and payment could go down -- though that's more likely if you bought or refinanced your home at a time when rates were high.

Reasons to avoid an adjustable-rate mortgage

While ARMs offer some material benefits, the risks are significant. (In fact, ARMs played a role in the 2008 financial crisis, before which they were marketed to homebuyers who did not understand the risks. The good news is ARMs are more tightly regulated now and that the riskiest versions have been retired.

"The two big ways ARMs have changed since the mortgage crisis is in product and prevalence," says Swaleh. "Prior to the 2008-2011 collapse, ARMs made up a sizable portion of all mortgages originated. Today, they do not. In 2020, my team did 540 loan transactions. Not a single one of them was an ARM. As far as products go, the two most dangerous products (interest-only and negative-amortization loans) are far less available."

Still, there are some serious disadvantages to consider before taking on an ARM:

Monthly payments can increase: This is the most obvious risk you're taking with an ARM, and it can be significant -- even if your loan has caps. Make sure you understand your ARM's indexes and caps so you can calculate potential future payments.
Negative amortization: As noted, payment caps can create a dangerous situation in which your loan balance can actually increase if you're not paying enough toward the principal.
Difficult to build into a budget: You may have good reason to believe that your income will increase or rates will go down, but if 2020 taught us anything, it's that nobody can perfectly predict what will happen in the next few years. Could you handle a payment increase even without a raise? Do you have money saved in case you were to lose your job or take in less income? If not, then you may want to think twice about an ARM.
Prepayment penalties: Some ARMs have prepayment penalties to prevent you from paying any extra principal or paying off the loan in advance. Be sure to ask your lender about any payment penalties before you sign off on a loan.
Complicated fee structure: Some lenders structure their ARMs with complicated discount points that provide an even lower rate initially. Some ARMs also have origination fees, funding fees, and other costs associated with this type of mortgage product that you should talk to your lender about. This fee structure can further obscure the actual cost of your loan and make it harder to know if you're really getting a good deal.

How to apply for an adjustable-rate mortgage

If you decide to apply for an ARM, you'll find the steps are basically the same as they would be for any loan, but you should proceed with a little extra caution.

First, review your credit and clean up any errors. If you need to improve your credit to increase your chances of locking in a better introductory rate, you may want to wait a few months.
Determine what you can afford in terms of money down and monthly payments. Remember that the latter can change with an ARM, so be sure you are planning with this in mind.
Get loan estimates from several lenders so you can compare rates, fees and closing costs. If you apply with several lenders within a short period (usually 30 days or less), the credit checks won't count as multiple inquiries on your credit report.
Ask lenders about important aspects of ARM loans such as rate caps, negative amortization, discount points and the index used to determine your rate. Make sure you have all of this information before moving forward.
Compare ARM terms to your fixed-rate options. Even if you're convinced an ARM is the best option for you, it's always helpful to explore all of your options before making a large financial decision.
Get preapproved for an ARM. Next, you'll want to begin the application process and get preapproved so you can determine how much house you can comfortably afford.
Finalize your ARM paperwork. Once you've been preapproved and decided on a lender, it's time to select the product that's best for your financial situation and sign your loan paperwork.

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