If you’re shopping for a home for the first time, you’ve probably heard of an Adjustable Rate Mortgage, or ARM. It’s a type of home loan with an initial low rate for a fixed period of time, which then increases or decreases depending on mortgage interest rates at the time of adjustment.
The advantage of this product is its initial low rate, making it an attractive choice for homebuyers because it offers more buying power. Also, the initial low rate can be fixed for up to a period of up to 10 years before the first adjustment. This offers homebuyers an opportunity to save and invest money.
To really understand how ARMs work and to grasp how your payments may change over the life of the loan, here are three things every homebuyer should know before applying for one:
1. The initial and future adjusted rates are determined for example by federal interest rates and your lender, as well as a pre-determined margin.
our initial rate may reflect a discounted or reduced margin - Future adjusted rates may reflect a higher margin. All margins are disclosed fully in your loan documents and ARM disclosure. The combined index plus margin determines the actual interest rate.
2. Your initial rate may be much lower than the future adjusted rate.
ARMs are structured so they offer borrowers a low initial rate for a fixed number of months or years. Depending on your specific loan, that rate may last anywhere from a month to several years before it changes. Once the fixed period is up, ARM loans can adjust. Initial and subsequent adjustment periods are outlined in your ARM disclosure and key mortgage documents such as the Deed of Trust and Note.
Pro tip: make sure you ask your lender about the Annual Percentage Rate (APR) of the loan. APR calculations for Adjustable Rate Loans are designed to reflect highest or worst case adjustments for the initial adjustment period, enabling borrowers to better understand the potential impact of adjustments at the appropriate time.
Adjustment periods deflect maximum upward interest rate adjustments to protect the borrower from experiencing payment shock or lack of planning for the payment increase.
3. Caps give homebuyers some control over how much their payments change
ARMs have two kinds of rate caps – a periodic adjustment cap sets a ceiling on how high the rate can change between adjustment periods, while a lifetime cap limits increases over the duration of the loan
As an example, your ARM loan may offer a 2.00% rate maximum or cap during the initial adjustment period, even if the index and margin would indicate a higher adjusted rate. This protects the borrower from payment shock.
Another example is an ARM that may offer a lifetime maximum cap of 6.00% means a borrower’s rate can never adjust by more than a total of 6.00% above the initial rate over the lifetime of the loan. This protects the borrower from a large increase in interest rates over time.
Finally, a borrower’s rate can also decrease at adjustment periods - the floor provides the lowest the borrower’s rate could go at anytime during the life the loan. For example, the floor might be 2.50%. This means the borrower’s rate can adjust down to 2.50% but no lower during the lifetime of the loan.