September 6, 2022
If you are in the market to purchase a home, one mortgage option you might consider is an adjustable-rate mortgage (ARM). These mortgage loans offer an alternative to 20- or 30-year fixed rate mortgages and might allow you to purchase more home for your money. With an ARM, you will enjoy an initial fixed-rate period lasting for three, five or seven years. Once the initial period ends, the rate will adjust according to market rates based on a specific index. After that, the interest rate on your loan will be adjusted each year for as long as you hold your mortgage.
Following the collapse of the housing bubble in the mid-2000s, ARMs have been viewed as less desirable options than fixed-rate mortgages. However, regulations have made adjustable-rate mortgages safer for borrowers by ending predatory lending practices and ensuring borrowers who receive mortgages are capable of repaying them. ARMs are no longer considered to be subprime loans, and they can offer homebuyers a lower interest rate, adjustment caps, flexibility and an easier application process. Here are four benefits of an adjustable-rate mortgage to understand as you are considering your mortgage loan options.
1. Lower Interest Rates
Depending on the terms of your adjustable-rate mortgage, you will enjoy an initial fixed rate lasting from three, five or seven years that will typically be lower than the rates for fixed-rate mortgages. This means that the payments you will make during the fixed-rate period will likely be lower than the monthly payments you would otherwise have to pay for a fixed-rate mortgage during the same period.
Once the initial period is over, the interest rate on your loan will adjust with the interest rates in the market at that time. Your mortgage payments are partly determined by the interest rate on your mortgage loan. If the interest rate increases after the initial period, your payments will also increase. However, if the interest rate falls, your payments will decrease. Lenders determine the interest rate on ARMs by using a market index and combining it with a set margin.
In most cases, you can expect to receive a lower rate during the initial fixed-rate period of your ARM since you will be assuming the risk that the market interest rates might rise instead of the bank assuming the risk. For example, if you opt for a 20-year fixed mortgage, the bank won't be able to increase your payments to account for higher interest rates in the market. At the same time, the bank won't decrease your payments on a fixed-rate mortgage if the interest rates fall. If the interest rates in the market decrease following the initial fixed-rate period of an adjustable-rate mortgage, you can take advantage of the lower interest rates without needing to refinance your mortgage.
If you don't plan on remaining in your home for a long time, the initial interest rate on an ARM can also benefit you. If you sell your home before the initial period ends, you won't ever need to worry about the interest rate on your loan adjusting. You can also take advantage of the lower payments during the fixed-rate period to make larger payments, helping to decrease the principal balance on your mortgage before your rates adjust.
2. Adjustment Caps
While the end of the initial period will result in an adjustment of your interest rate, it could move higher or lower based on the cost of borrowing and the economy. This is one reason why some borrowers are hesitant about taking out adjustable-rate mortgage loans. However, ARMs have adjustment caps that restrict the amount by which your interest rates and payments can rise each year or over the life of the mortgage.
The caps on an ARM can work in one of the following ways:
- Periodic cap - Caps the percentage by which the interest rate can change over a set period
- Lifetime cap - Caps the amount by which the interest rate can increase over the loan's life
For example, if you have an ARM with a periodic cap of 1% per year, this means that your interest rate can't be increased by more than 1% each year. If your rate is adjusted by 1% during a year, your lender can't increase it beyond the cap even if the market rates increase by 2% during the same year. Caps help to make your payments more predictable.
One great advantage of adjustable-rate mortgages is their flexibility. You can opt to convert your loan to a fixed-rate mortgage after your initial period ends, which can be attractive when the economy is uncertain. It is also a good choice if you think you might want to sell your home within a few years and move. In that situation, you could benefit from the lower interest rate and payments during the fixed-rate period and sell your home before it adjusts.
4. Easier Application Process
An application for an adjustable-rate mortgage is typically easier than the process involved with a fixed-rate mortgage. You can expect less paperwork to be involved and for the process to take less time, which might allow you to buy the home you want without risking losing it to a different buyer.
Buying a home is an exciting process. When you are considering different mortgage loan products, you shouldn't overlook an adjustable-rate mortgage. Depending on your situation, an ARM might make the most financial sense and offer the greatest benefits. To learn more about mortgage options and which might be the best for you, talk to the mortgage professionals at La Capitol Federal Credit Union today.