How an adjustable-rate mortgage works vs. a fixed

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There is more than just one type of mortgage that is available to homebuyers in the marketplace. Everyone is familiar with the conventional type.  You simply pay the same mortgage payment each and every month.  But did you also know that an Adjustable Rate Mortgage is another option?

Most people think of the “Great Recession” when they think of adjustable-rate mortgages. But it’s the subprime mortgages that played a huge role.  Subprimes were the mortgages that were allocated to home buyers that had low credit scores and no income.

Let’s go over what an adjustable-rate mortgage is, provide examples, and explain how it is similar and different from your standard fixed-rate mortgage. Before we get started, ARM’s do carry more risk. If you don’t like risk, renting an apartment is always a safe play.

What is a Fixed-Rate Mortgage

Also known as a conventional mortgage, the interest rate on a fixed rate won’t change. Buyers make the same monthly payment every month. It doesn’t matter if the interest rates increase or decrease in the marketplace, as the rate was already locked in when the buyer was approved for the home.

A fixed-rate mortgage provides a buyer with a significant amount of confidence knowing exactly how much they have to pay monthly. There aren’t any surprises.

What is an Adjustable Rate Mortgage

An adjustable-rate mortgage in the simplest terms has an interest rate that can and will change throughout a mortgage loan. What most people don’t know is that although the rate can increase, it can go down as well.

A buyer might be able to make lower mortgage payments if interest rates in the environment decrease. This is exactly what has been occurring in the marketplace today.

Finally, the only reason anybody would ever want to entertain an adjustable-rate mortgage is for the preliminary low-interest rate. It’s always going to be lower than the rate a conventional mortgage provides. This can result in huge savings for buyers.

 But unlike its fixed-rate brethren, there is much more to know about an ARM.

Components of an ARM

Each ARM will have a “Teaser” rate. This is the introductory interest rate. The period could be for as little as one year. Or it could be 3 years, 5 years, 7 years, or even longer.

1. During this introductory period, the rate on the ARM cannot move. Think of this period as similar to a fixed interest rate.
2. After the introductory period expires, the rate on the mortgage can move based upon market conditions. Periods might be as little as 1 year or even longer.
3. Each ARM will have rate caps built-in which will limit the increases in the interest rate for each period, and over the life of the loan.

Rate Caps

ARM mortgages will have caps. These caps will limit how much the interest rate can change each time the mortgage resets, and over the life of the loan.

The reason caps are put into place is to prevent huge rate increases that will result in substantial mortgage payments. Lenders realize that the owners won’t be able to afford these higher mortgage bills. Thus, caps were put into place to limit how much the interest rate can increase.

Initial Rate Cap:

After the introductory period has expired, there will be a limit on how much the interest rate can change. Buyers will find this information in their loan documentation.

Subsequent Caps:

ARM’s will have many rate adjustment periods. Again, there will be caps in place for each of these periods.

 For example, if the rate on the mortgage is 3%, and the loan documentation dictates that rate increases will be limited to .5% for the adjustment periods, the maximum the new rate could increase to would be 3.5%.

Maximum Rate Caps:

Each ARM will have a maximum interest rate that the loan can carry. If this rate is reached, the interest rate can no longer increase. At this point, the mortgage payment will have reached its maximum.

All ARM’s are tied to a benchmark. This will determine how the rate will adjust. You can read more about benchmarks online.

Real LIfe ARM’s in Action

There are a variety of ARM’s in the marketplace. They all will have an introductory period and several adjustments. Here are a few of the most popular types of adjustable-rate mortgages in the wild.

The first numerical digit represents the intro period in years, while the second will indicate how often the rate will reset after the intro period has expired.

7/1 ARM

The 7 (in years) represents the length of the initial fixed-rate portion of the adjustable-rate mortgage. Starting the 8th year, and every year thereafter, the mortgage is then able to reset to market conditions.

This will continue until the buyer pays off the home, sells it, or refinances it. The 7/1 allows a pretty length fixed-rate period. The buyer won’t have to worry about any increases in the immediate future.

1/1 ARM

At the opposite end of the spectrum is the 1/1. There isn’t much of an introductory rate period. The ARM resets every year.

The advantage of the 1/1 is that the initial interest will be very low. However, the buyer won’t have much time before it resets again (just 12 months). This wouldn’t be the type of ARM for someone who is risk averse.

3/3 ARM

In this scenario, the buyer will have an intro period of 3 years. Starting year 4 the interest rate can reset, and this will also be the rate for years 5 and 6. This process will repeat for years 7, 8, and 9, and so on.

This type of ARM has both its pros and cons.

•  If rates were to spike in year 3, then the rate would most likely adjust up, and be fixed for years 4, 5, and 6. Even if the rates were to go back down again in year 4, the buyer would be locked into this rate until the end of year 6.
• The opposite also holds. If rates were to spike in the middle of year 4, the buyer’s interest rate couldn’t possibly go up until year 7.

An adjustable-rate mortgage calculator that can show just how much payments can go up or down given a certain rate increase. Check out how a 2 step mortgage works if you can’t stand risk.

What Type of Buyer Should Consider an ARM

• A buyer who knows that won’t be living in the home for more than 5-7 years. Maybe their company moves them around the country quite a bit. Or maybe it is someone who never stays in the same place very long. Either way, they could sell their home before the rate might adjust.
• Someone who will be making more income in the future. They get to enjoy the benefits of lower initial interest rates. If rates did go up in the future, they would be making more money and could absorb the higher payments.
• A speculator who purchases a home in a market they believe is going to be hot in the future. They want the lower initial interest rate and will be selling the home in the near future for a profit and won’t have to worry about the rate resetting.

Final Take-Aways

• ARM’s are simply another type of mortgage that can fluctuate with the market.
• The interest rate can go up or down based upon market conditions.
• A buyer can always sell their home or refinance in the case they aren’t comfortable with their current mortgage
• Without a doubt, buyers should opt for a conventional mortgage if they are on a fixed income

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