Low starting rates and flexibility are advantages; disadvantages include complexity and the potential for significantly larger payments over time.
An adjustable-rate mortgage, or ARM, is a house loan that begins with a low fixed-interest “teaser” rate for three to ten years, then adjusts at regular intervals. ARMs differ from fixed-rate mortgages in that the interest rate remains constant during the loan term.
How Does an Adjustable-Rate Mortgage Work?
When you take out an adjustable-rate mortgage (ARM), you pay a fixed interest for a set number of years during the adjustment period—anywhere between three to ten years. You can then choose to refinance or pay the loan off.
After the adjustment period, your interest rate will periodically adjust based on a formula set when you took out the loan. Typically, the rate will go up or down based on changes in a benchmark index, such as the U.S. prime rate.
If interest rates go up, payments monthly will go up, too. If interest rates go down, your monthly payments may stay the same or go down.
For example, you might take out an adjustable-rate mortgage with a 3.5% fixed rate for the first five years. If you keep the mortgage loan for the full five years, you’ll have an interest rate that’s locked in for an additional five years.
But if you refinance or pay off the loan during that period, your interest rate will go up or down every year based on changes to a benchmark rate, such as the U.S. prime rate.
The Advantages of an Adjustable-Rate Mortgage
The interest rates with ARMs can be lower than fixed-rate loans. That means you’ll be able to take advantage of a low-interest rate if you keep the loan for the entire adjustment period.
In addition, you may be able to qualify for a lower monthly payment with an ARM since initial payments are typically lower than fixed-rate loans. As such, you’ll have the chance to adjust to any changes in your financial situation when the interest rate adjusts.
The Disadvantages of Adjustable-Rate Mortgage
One disadvantage of ARMs is that there are no initial rate guarantees that your low-interest rate will stay low. In fact, rates with ARMs have been higher than fixed-rate loans. If the market changes and mortgage interest rates increase, you may wind up paying more in total interest over the loan term.
Most mortgage lenders will also require an application fee, which could cost $50 to several hundred dollars. The fee helps cover the lender’s expense of pulling your credit report. It may vary depending on the amount of the loan and your credit history. There’s no need to add a fee to your mortgage payment—the lender will add the cost to your loan, and you can opt to pay the fee upfront or roll it into your mortgage.
In addition, a mortgage broker may charge a commission, which is typically 1 to 2 percent of the value of your loan. Thankfully, you can ask the lender to waive the fee if you get the mortgage through a broker you know and trust.
Another disadvantage of ARMs is having to provide proof of income, such as your latest pay stubs. Lenders will probably ask to see two years of tax returns to confirm that your income meets your loan requirements. You might also have to provide proof of your assets, such as bank statements and retirement fund documentation.
When it comes to financing a house, it’s essential to consider all the factors involved, including the interest rates, amortization, the fees and payments, and the prepayment penalties. It’s important to consider what you have at your disposal and make the best choice possible.
A mortgage calculator is a valuable tool in helping you make an informed decision about the mortgage rate and the loan terms that are best for you.
At Hawkins Home Loans, we’re here to make your home loan application experience as efficient and straightforward as possible. Whether you’re buying a home, refinancing, needing cash from your home equity, Hawkins Home Loans is your online resource for a worry-free process, incredibly low rates, and fantastic service. Reach out to us today for assistance in applying for home loans in Sacramento, CA!