Flexible Financing: Exploring the World of Adjustable-Rate Mortgages

Buying a home is an exciting step that requires making many decisions, like picking the right mortgage to fit your financial goals and current situation. One option to think about is an adjustable-rate mortgage (ARM). ARMs have their advantages and disadvantages, so think carefully before deciding on a home loan.

Understanding Adjustable-Rate Mortgages (ARMs)

An adjustable-rate mortgage (ARM) is a loan in which the interest rate can change over time, which means your monthly payments might go up or down along with it. It’s different from a fixed-rate mortgage (FRM) because with a fixed-rate loan, your interest rate is set when you take out the loan and stays the same throughout. This means your monthly payments remain unchanged.

An ARM has two components:

• Fixed-rate period: At the beginning of the loan, the interest rate remains fixed for a set number of years. It’s usually three, five, seven, or 10 years.
• Adjustment period: After the fixed-rate period ends, the interest rate adjusts, typically every 12 months.

Different Types of ARMs

Lenders offer various types of ARMs – 3/1, 5/1, 7/1 – and their names indicate:

• The length of the initial period (the first number)
• The frequency that the rate can adjust during the adjustment period (the second number).

For example, let's take a 5/1 ARM, which is the most common type. It means you’ll have a fixed rate for the first five years, during which the interest rate won’t change. After that, the ARM will adjust once a year. The same principle applies to 5/1 and 7/1 ARMs. If rates increase, your monthly payments will increase; however, if rates go down, your payments are not guaranteed to decrease; it will depend on your initial interest rate.

Rate Caps on ARMs

Most ARMs incorporate a rate cap structure designed to limit potential increases or decreases in your interest rate.

While adjustable-rate mortgages typically begin with lower interest rates than fixed-rate mortgages, this initial low rate may change after the fixed-rate period. Consequently, your payments may fluctuate. However, payment caps exist to restrict how much your mortgage rate and monthly payment can increase.

These caps include:

• Initial adjustment cap: Limits the maximum interest rate increase during the first payment adjustment.
• Subsequent adjustment cap: Limits rate increases for subsequent adjustments after the first.
• Lifetime adjustment cap: Imposes a maximum limit on rate increases over the loan’s duration. For example, the rate cannot exceed a 6% increase over the loan term even in volatile market conditions.

With an ARM from American Heritage Credit Union, after the fixed-rate period ends, the rate can change every year (12 months) thereafter. The variable rate is based on the one-year Constant Maturity Treasury (CMT) yield, plus a fixed margin of 3.00%. The rate cannot increase or decrease by more than 2 percentage points annually or more than 6 percentage points over the life of the loan.

When to Consider an ARM

Why would you consider an adjustable-rate mortgage when a fixed-rate mortgage guarantees that your interest rate won’t increase? The answer is simple: to pay less each month at the beginning of the loan term. ARMs can be a smart choice in the following situations:

• You plan to sell your home: If you’re going to sell and move before the fixed-rate period ends, an ARM might be your best bet. This is particularly true for starter homes.
• You expect your income to increase: With low initial interest rates and monthly payments, you can time the adjustment period to coincide with a windfall or significant income boost.
• You’ll be paying off the mortgage soon: If your goal is to pay off the mortgage before the fixed-rate period concludes, make sure there are no prepayment penalties associated with your ARM.

There are several benefits to financing your home with an ARM:

• Low payments during the fixed-rate phase: Your introductory interest rate remains unchanged, providing you with predictable low payments.
• Flexibility: If you know you’ll be selling or paying off the mortgage before the payments become less predictable (during the fixed-rate period), an ARM offers flexibility.
• Potential payment decrease: If interest rates drop, your monthly payment during the adjustment period could also decrease.

However, there is some uncertainty associated with ARMs regarding potential payment increases or decreases. Depending on the market, your rate could adjust upward, resulting in higher monthly payments. It’s crucial to keep this in mind because you’re responsible for making your monthly payments even if your rate goes up. You might also incur a penalty if you try to pay off the loan early in the hope of avoiding higher payments.

Knowing all the facts can help you make an informed decision.