What is an Adjustable Rate Loan?
When you borrow money by taking out a loan, you will be paying back this loan with interest.
It is the interest that drives how expensive a loan is. There are other fees involved, but the interest rate determines the bulk of the cost of a loan. The higher the interest rate, the higher the costs you will be paying.
In a fixed rate loan, the interest rate is the same for the entire length of the loan. You will be paying the same monthly payment every month.
➤ Related article: What is a Fixed Rate Loan? (Comment: Make this line clickable to Fixed Rate Loan article when publishing.)
So what is an adjustable rate loan? What is an adjustable rate mortgage?
An adjustable rate loan which is commonly referred to as ARM for adjustable rate mortgage is a type of mortgage where the interest rate on the outstanding balance varies throughout the life of the loan. However, the initial interest rate is fixed for a period of time and after that it resets periodically based on the type of ARM you select. The two most common ARM adjustments periods are yearly and monthly.
Essentially, an ARM simply means the interest rate may change throughout the life of the loan which consequently means your monthly payment can go up or down.
ARM’s are usually not a highly recommended loan option because they do have increased risk. Remember if the interest rate adjusts higher then so will your monthly payment.
That being said at times it can be a perfect option for homebuyer(s) who expect to own the house they are purchasing for only a few years.
For instance, if you know you are only going to live in the house for only five years maximum, and then plan to move to another place after that, a 5/1 ARM loan is perfect because the introductory interest rate lasts for five years before it resets or adjusts.
Since the real estate market crash of 2007, adjustable rate mortgages have bounced back. Statistics show that it represents 14% of the dollar volume on mortgage applications in 2018.
How does an adjustable rate mortgage work?
Normally, the initial interest rate of an ARM is fixed for a period of time. And it is usually lower than that of a fixed rate mortgage.
After that set period of time, the interest rate resets periodically — annually or even monthly.
The interest rates resets based on a benchmark or index, plus an additional spread known as the ARM margin.
The most popular adjustable rate mortgage is the 5/1 ARM. It carries an introductory fixed interest rate for the first five years of its term, along with fixed principal and fixed interest payments. After the initial period of five years of the loan, the interest rate will then adjust depending on different factors. In other words, at year six, the interest rate resets and your monthly payment will surely change.
Adjustable rate mortgages of type 3/1, 7/1, and 10/1 are also available. The first number indicates the number of years that the introductory interest rate remains fixed before it resets.
What is better fixed or adjustable rate mortgage?
In order to determine what loan option is better for you, the question to ask is, “How long do you plan on staying in the home?”
“How long do you plan on staying in the home you are buying?”
Depending on your plans for the house you are purchasing, an ARM could be a better option for you.
If you don’t plan on living in one place for very long, you can take advantage of the low introductory rate of an adjustable rate loan.
If, for example, you plan on moving out after seven years, the 7/1 ARM might be a better option. You can sell the house before the interest rate adjusts and you would have had only to pay for a low introductory interest rate.
But if you plan on staying for a long time, or you don’t know when you will be moving out, you run the risk of making higher monthly payments when the rate adjusts after seven years. In this case, a fixed rate loan might be a better choice.
Since statistics show that interest rates have steadily increased since 2016, you can’t bank on the chance that the interest rate will adjust to a lower rate. So if you know you will stay in the house your are buying for a long time, a fixed rate loan offers you a fixed monthly payment.
An ARM can save you a lot of money because of the low introductory interest rate in the short term. But holding one when the interest rate adjusts higher after the introductory period, your monthly payment will increase and might be a problem to your budget.
How often does an adjustable rate mortgage adjust?
Lenders base ARM rates on various indexes, benchmarks, and/or a spread. It is a good idea to have the lender explain which index is used as a basis for the rate adjustment and examine how it has fluctuated in the past.
Secure Choice Lending loan experts can explain this to you and examine with you the rate fluctuations in the past.
The period between interest rate changes is called the adjustment period.
An adjustment period of one year means the interest rate would change once every year. This also means your monthly payment will change every year upon adjustment.
An adjustment period of three years means the interest rate, and thus your monthly payment, would change once every three years.
A 5/1 ARM has an introductory fixed rate for five years and an adjustment period of one year after that.
A 7/1 ARM has an introductory fixed rate for seven years and an adjustment period of one year after that.
To avoid hardship due to payment shock, you have to be aware of the interest rates as your adjustment period approaches. But expect to be notified of an adjustment and a new payment well in advance.
Knowing your new payment ahead of time can help avoid problems with payment and give you some time to explore your loan options.
Secure Choice Lending can assist you with an Adjustable Rate Mortgage
Taking on an adjustable rate loan doesn’t have to be a risky exercise. You just need to understand what to expect.
If you think an adjustable rate mortgage is right for you, Secure Choice Lending can help.
Just call us at 951-733-8925.
Our Loan Officers will be happy to answer all your questions and discuss your options until everything is clear to you.
Secure Choice Lending is a full service mortgage broker that will secure you a mortgage that doesn’t break the bank.
To streamline the lending experience, our team of financial experts matches consumer needs with the appropriate loan programs and level of risk. With loan officers versed in all mortgage types, solutions to your home-buying questions are a phone call away.