What Is An Adjustable-Rate Mortgage?
Nowadays, getting a loan has become quite easy. If you have a good credit score and a steady income, a lender will happily let you borrow money, whether you are applying for a personal loan or a mortgage.
Regarding a mortgage, you have probably come across two popular terms: Adjustable-Rate and Fixed-Rate. The terms themselves are self-explanatory.
An adjustable-rate refers to an interest rate that changes according to the market, whereas a fixed-rate interest rate stays the same throughout the life of the loan. Let’s explore the adjustable rate in detail and its types:
What Is An Adjustable-Rate Mortgage (ARM)?
An ARM on a home loan changes periodically. The interest rates will either go up or down. The lender quotes a low-interest rate initially, which continues for a few years. After that, the interest rate changes based on the housing market. This mortgage type is in contrast to a fixed-rate mortgage. We review the terms for the types of ARMs:
This adjustable-rate mortgage model is the most common. The ‘hybrid’ in its name refers to its two parts. The first part of the loan consists of only paying a fixed interest rate for around ten years. Once the period for the first part ends, the second period begins, in which the interest rate either decreases or increases.
Hybrid ARM Examples
3-Year ARM: For 3 years, the interest rate is fixed, and then it changes after every 6 months.
5-Year ARM: For 5 years, the interest rate is fixed, and then it changes after every 6 months.
7-Year ARM: For 7 years, the interest rate is fixed, and then it changes after every 6 months.
10-Year ARM: For 10 years, the interest rate is fixed, and then it changes after every 6 months.
As the name says, in this adjustable-rate mortgage model, you only pay the interest for a set period. Once that ends, your monthly payments include the remaining interest and principal.
During the interest-only period, the payments are quite low. However, a downside of this ARM model is that you don’t build equity unless your home’s value increases.
After the Great Recession in 2008, millions of homeowners couldn’t pay their mortgages and lost their houses. Hence, banks and lenders decided to offer people a flexible option that would allow them to make monthly payments easily.
This ARM model allows borrowers to customize their mortgage payments. They can choose from three options: A minimum payment with less interest, interest-only payment, or interest and principal payments. This model is risky because if you make minimum payments and the interest rate increase, you will have to pay more after your period ends.
ARMs come with a cap, meaning the lender will let you know the maximum interest rate amount. This allows you to prepare in advance and have a backup plan in case the interest rate increases.
While choosing ARM is risky, it allows you to take advantage of the fall period when the interest rate decreases. A fixed-rate mortgage does not offer this advantage.
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