If you’re shopping for a home, it’s important that you know what an adjustable rate mortgage, often referred to as an ARM, is. This is a home loan that has a variable interest rate. The initial interest rate is fixed for a specified period of time. After that, it will reset at certain intervals- at least annually, and sometimes monthly.
An adjustable rate mortgage is also referred to as a variable-rate or floating mortgage. The interest is reset based on a benchmark/index as well as a spread known as an ARM margin.
Types of Adjustable Rate Mortgages
There are three types of adjustable rate mortgages, which we will explore below:
A hybrid ARM offers a combination of fixed- and adjustable-rate periods. The interest rate is fixed to start with and then floats after a certain amount of time. It is usually expressed in 2 numbers. The first number indicates how long the fixed rate applies and the second indicates the duration or adjustment frequency. For example, if you have a 2/28 ARM, the rate will be fixed for two years and then will float for the remaining 28. On the other hand, a 5/1 ARM has a fixed rate for the first 5 years and adjusts every year after that.
In the case of an interest-only ARM, you will only be paying interest for a specified period of time, which typically ranges from 3 to 10 years. At the end of that time, you will pay both interest and principal.
In the case of a payment-option ARM, you have options for making your payments, which are usually:
- Payments covering principal and interest
- Paying just the interest
- Paying a minimum that doesn’t even cover the interest
While paying the minimum may sound appealing, it’s important to keep in mind that you will ultimately be required to pay back the entire amount by the date listed in your contract and that interest is higher when you’re not paying off the principal.
How is the Variable Rate on an Adjustable Rate Mortgage Determined?
When the initial fixed-rate period ends, the ARM interest rate will fluctuate based on a reference rate- the ARM index- plus a set amount above that- the ARM margin. While the index may fluctuate, the margin remains the same. If the index is 5% and the margin is 2%, the mortgage will adjust to 7%. If the index drops to 2% next time the rate adjusts, the margin is still 2%, so the rate drops to 4%.
The interest rate on an ARM is set by a benchmark rate that fluctuates based on the general state of the economy as well as a fixed margin charged by the lender.
How do You Know if an ARM is Right for You?
If you plan to keep the loan for a limited period of time and can handle the rate increases, an ARM may be a wise financial move for you. Most of the time, an ARM has a rate cap that limits how much the rate can increase.
A periodic rate cap limits changes in the interest rate from one year to the next but a lifetime rate cap will limit how much the mortgage can go up for the life of the loan.
Some ARMs have payment caps limiting the dollar amount of how much the monthly payment can be increased. That being said, if your monthly payments don’t at least cover the interest payments, you could end up with negative amortization. This means that despite the fact that you are making payments, the amount you owe will never decrease.
If you’re interested in purchasing or refinancing a home in South Carolina, contact Covenant Mortgage Services to learn more about ARMs and other mortgage types. We believe that the best mortgage is the one you can afford – and still have the life you’ve become accustomed to. Let our expertise help guide you in choosing the right option for your unique situation.