To find the right home loan for your own personal situation, it is important to analyze your finances and choose the type of loan that fits your budget and investment strategy best. To choose wisely, it is essential to be fully informed about the implications of each type of loan. Here, I'll explain what adjustable rate mortgages (ARM) are, so that you can better decide if it's the right kind of home loan for you.
There are two main mortgage categories, and both of them have many variations. The categories are ARM loans and fixed-rate mortgage loans. ARM loans adjust or fluctuate with the market, which means that you will pay more if the rate goes up, and less if it decreases.
ARM loans are a popular type of home loans because initial mortgage payments are usually lower than fixed-rate mortgages. Borrowers choose ARM loans because a lower initial payment makes their home more affordable. However, since rates fluctuate it can also be risky if rates were to rise.
Types Of ARMs
Most ARMs have an initial fixed-rate period with the lower starting rate, after that there is a much longer period during which the rate fluctuates and changes at preset intervals. The standard is a 5/1 ARM, which means that the fixed-rate period lasts for five years. After that, the rate is adjusted each year. The first number represents the number of years with a fixed-rate, the second number is the number of years after which the rate is adjusted. For example, a 3/1 hybrid ARM means that after 3 years with a fixed-rate, the rate will be adjusted annually thereafter. Other popular ARM loans include 3/1, 7/1 and 10/1.
ARMs And Their Features
The majority of ARM rates are linked to the performance of three indexes: the LIBOR (which stands for London Interbank Offered Rate), COFI (Cost of Funds Index), and the weekly constant maturity yield on 1-year U.S. Treasury (CMT) securities. LIBOR is the most commonly used benchmark interest rate for ARMs. Generally ARMs come with certain caps to protect borrowers from extreme rises. The most common types of caps are: periodic rate cap, lifetime cap, and payment cap.
A periodic rate cap is a limit on the amount that a rate can change at any one time. These can come in the form of annual caps or caps that limit the rate from rising over a certain amount of percentage points a year. A lifetime cap is a limit on the amount that the interest rate can rise over the entire life of the loan. Some ARMs offer payment caps; this cap limits the amount of dollars that the periodic payment can rise over the life of the loan, instead of the rate in percentage points.
Some ARMs have a conversion possibility, allowing borrowers to change their loans to a fixed-rate mortgage for a fee. It is important to ask your lender if the ARM is convertible to a fixed-rate mortgage. This way you would be more flexible financially if you consider changing to a fixed-rate mortgage in the future. When getting a loan, it is also important to check if it is assumable. This means that when you sell your home, the new buyer may assume your mortgage too if he/she is eligible.
Should You Get An ARM?
Before choosing an ARM, make sure to evaluate the maximum rates it could rise to. After calculating the worst-case-scenario in which the rates rise to the maximum cap limit, check if you would be able to afford it. If your finances wouldn't be put in danger at the capped limits, you can consider getting an ARM to benefit from the initial low rates.
ARMs are a bit harder to understand than fixed-rate mortgages because you have to be aware of many factors simultaneously. If you are a first-time home buyer or you prefer knowing exactly what you have to pay each month, then you should look into the possibility of a fixed-rate mortgage before opting for any home loan.
To recap, the pros of getting an ARM loan reside in lower initial payments, on the downside, later on you are exposed to the potential risk of higher payments. Make sure you can afford to pay the maximum possible amount that the rates could rise to before getting an ARM loan. If you feel that ARMs are not worth the risk, take a look at fixed-rate loans to see if it's a better option for you.