A Look into Adjustable Rate Mortgages
An adjustable-rate mortgage is a mortgage in which the interest rate that is applied to the balance outstanding amount can vary throughout the existence of the loan.
At first the interest rate is fixed, which lasts for a certain period of time, then it resets periodically. This could be within a year or even month. The interest that resets is based on a benchmark or index, plus an additional spread called the ARM margin.
Each lender decides how many points will be added to the index rate. It is typically in the form of percentage points so, for example, if the Libor rate (this is the criterion rate which some of the world’s leading banks charge for short-term loans) is 0.5 percent, then the ARM rate could be between 2.5 percent to 3.5 percent.
A lot of lenders will keep the advertised rate for a specific period of time. After that time has passed, the rate will rise regularly.
This is also known as a reset. The rise of the interest depends heavily on the terms of the loan, so it can occur monthly, quarterly, annually, or every three or four years.
After the reset, the rate will increase in accordance with the increase in the Libor rate. This means that if the Libor rate increases even a little bit, you will see a significant rise in the amount you have to pay for the loan.
Advantages of choosing an ARM
The one advantage of an adjustable rate mortgages is that the rate for this mortgage is lower than that of fixed-rate mortgages.
The rates of fixed-rate mortgages are tied to the 10-year treasury note. This is a loan that you make to the U.S. government and it takes the entire country’s performance to be able to pay you back. The note rate is the yield or rate of return on your investment in this bill.
This means that later on, you can buy a bigger house for a much lower price. This is particularly helpful and attractive to the first-time home buyers.
Disadvantages of choosing an ARM
The biggest disadvantage of choosing an ARM is that your monthly payment can rise significantly if the rate of interest rises. For this, your income also has to rise or you may risk losing your home.
Why choose an ARM?
There are a lot of reasons why someone looking to purchase a home may choose the adjustable rate mortgage, such as:
- You are on selling a home of your own before the initial rate period comes to an end, so you can match the changing rate of an ARM.
- You can anticipate a rise in the rate of your income that would be enough to cover the higher mortgage prices in the coming years.
- You are trying to qualify for a larger loan so the initial lower payment of ARM would be beneficial, and you can use remnants of the loan, include it in your income, and be able to make bigger payments in the future.
An ARM may be a good choice for some, but you should calculate your risks before choosing this option. Talk to your lender or financial adviser to determine which type of mortgage makes the most sense for your personal situation.