How Does an Adjustable Rate Mortgage Work?

Are you thinking of taking an adjustable rate mortgage? It certainly has its benefits, including a lower initial payment during the first few years. Before you take an ARM loan, though, you should know how it works to make sure it’s in your best interest to take this type of loan.

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What is an Adjustable Rate Mortgage?

First, let’s look at the definition of an adjustable rate mortgage. As you can guess, the interest rate doesn’t stay the same – it adjusts. But, what many people don’t know is that the rate is fixed for the first few years. It depends on the type of ARM you choose. For example, a 5/1 ARM would have a fixed rate for the first five years and then adjust every year after that. A 7/1 ARM would have a fixed rate for the first seven years and then adjust every year after that.

The rate then adjusts once a year on the adjustment date. It adjusts according to the index the lender chose for your loan. It also adjusts according to the chosen margin for your loan. The index is ever changing; you’ll never know where it will land. The margin, however, remains the same for the life of the loan. The lender adds the margin to the current index value to come up with your new rate on your adjustment date.

What is the Rate Index?

Lenders have a variety of indexes to choose from when giving you an ARM rate. Typically, they base your rate on the LIBOR, Treasury securities, or the Cost of Funds Index. Make sure you ask a potential lender which index they will use in order for you to make a decision. While you can’t predict the future, you can look at the history of the index to see how it might perform.

What is the Margin?

The lender chooses the margin based on their own preferences. The margin is just a percentage that they add to the index. You’ll likely find different margins from lender to lender. You can compare offers from lenders that use the same index, by comparing the margins they offered.

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The Maximum Percentage Changes

Luckily, each ARM loan has caps or a maximum amount that they can change during periodic intervals. You’ll see a variety of caps on an ARM loan including:

  • Initial cap – This is the maximum amount that an interest rate can change during your first rate change.
  • Periodical cap – This is the maximum amount that an interest rate can change from one period to the next.
  • Lifetime cap – This is the maximum amount the interest rate can change over its lifetime. If it ever hits this point, it can’t go any higher. This is usually 5%, but it can vary by lender.

Knowing the caps on your interest rate, you can tell the worst-case scenario for your interest rate. This allows you to figure to the payment and see if it’s something you can comfortably afford. If you can’t, you know that the ARM rate isn’t right for you.

The adjustable rate mortgage is a tricky one. It’s a good option for borrowers that know they will move or refinance before the rate adjusts. It’s also good for borrowers that need that little bit of extra wiggle room in their debt-to-income ratio. The lower initial payment may allow you to qualify for more loan, helping you to become a homeowner.

It’s always a good idea to see all of your loan options. If you think you want an ARM loan, you should still get a rate quote for a fixed rate loan. This way you know what options you have. You may be surprised to learn that the fixed rate loan is more affordable than you thought. This could be a good option if you know you are staying put. Either way, explore your options and figure out which loan works the best for you.

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Justin McHood is a managing partner at Suited Connector and has been recognized by national media outlets as a financial expert for more than a decade.

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