We’re not talking about Harrison Ford’s infamous movie The Fugitive with the one-armed man, which if you haven’t seen, we highly recommend. We’re talking about a mortgage loan product that’s been around since the 1980s (unlike The Fugitive, which was released in ’93). And we’re exploring why this could be a good option for you if you’re thinking about purchasing a home this year.
Besides an appendage, what is an ARM?
ARM, in the mortgage world, stands for adjustable-rate mortgage. This loan product offers a variable interest rate that will change over time, based on what’s happening in the market. Often, someone’s draw to an ARM is that its initial interest rate is most likely lower than one you’d find paired with a fixed-rate loan (like what you get with a conventional or FHA product).
Because an ARM may charge less interest during its introductory period, it offers a lower initial monthly payment. After that initial period though, changing interest rates will impact your payments. If interest rates go down, ARMs can become less expensive than fixed-rate mortgages; if interest rates rise, an ARM can become more expensive.
The initial interest rate will last anywhere from one month to 10 years — we’ll explain more on that later.
ARM terminology and how they work
ARMs are long-term home loans with two different “periods:” the fixed period and the adjustable period.
Fixed period
- The amount of time when you have a fixed rate (typically the first five, seven or 10 years of the loan). During this period, your interest rate doesn’t change.
Adjustment period
- The period when your interest rate can go up or down, based on market changes.
Fixed period/adjustment period example
- Most common ARM terms include 5/1; 3/1; 7/1; and 10/1
- The first number represents the number of years you have a fixed rate, and the second number represents how often the rate adjusts after that (once per year in the above examples).
For example, let’s say that you have a 30-year ARM with a five-year fixed period. If it’s a 5/1 ARM, after the first five years, your rate could go up or down once a year for the remaining 25 years of the loan.
But there’s another layer to understand as well …
Rate caps
- You may see another set of numbers paired with the term. Let’s use 5/1 again in our example. The new set of numbers will follow it in parenthesis: 5/1 (2/2/5). The second set of numbers – 2/2/5 – refers to details of the rate caps.
Initial adjustment cap
- The first “2” is the limit on how much your interest rate can adjust. So, at your first reset, after the 5-year introductory period, your ARM could increase your interest rate by up to 2% in year 6.
Subsequent adjustment cap
- The second “2” is the limit on your next interest rate adjustment. So, in year 7, your interest rate may rise again by as much as 2%.
Lifetime adjustment cap
- This cap lets you know how much the interest rate may increase in total over the life of the loan. In our example, in year 8 and thereafter, the interest rate can only increase by up to 1% more, which would equal 5% overall since the adjustments began. There’s where we get our (2/2/5).
You may also come across interest-only ARMs.
Interest-only ARMs
- An interest-only ARM will delay paying down your mortgage principal for a varying amount of time, because you’re only required to pay interest. Just note that you won’t be building equity in your home, and the interest payment may “float” and change each month, based on market conditions and the ARM loan you have.
Benefits & Risks
The biggest advantage of an ARM is that it may be cheaper than a fixed-rate mortgage during the fixed period, or, for a period of one, three, five, seven, or 10 years. Their low initial payments often enable you to qualify for a larger loan and let you enjoy lower interest rates (and lower payments) without the need to refinance your mortgage. And whose budget wouldn’t enjoy that?
This budget wiggle room may be the perfect option for those who know they’ll be moving in a short amount of time after their home purchase. If you plan to sell before the rate adjustment begins, you won’t be affected by it. This could very well be the perfect option for someone who’s only seeking a starter home right now and will live there only for a couple years, leaving the risks relatively minimal.
If you choose an ARM, you may save hundreds of dollars each month for up to seven years, after which the loan costs may rise because the new rate is based on where the market is, not your initial one. This is called the rate reset. Before the reset, you may have the ability to build your savings and focus on other financial goals.
Is an ARM right for you?
There are several scenarios where an adjustable-rate mortgage will be the right option for you. Because there are so many personal and economic factors to consider, there are a few questions you should consider that will help you get started:
- What mortgage payment can you currently afford?
- If interest rates rise, can you still afford an ARM?
- When do you intend to move next?
- What direction are interest rates heading in, and do analysts anticipate the trend to continue?
If you’re considering an ARM, have your loan officer help run the numbers to predict your best and worst-case scenarios. Can you afford the mortgage if it the max interest cap happens in the future? If so, an ARM can save you money every month before then.
Are interest rates high right now and predicted to fall? You may be able to take advantage of the drop, because with an ARM, you’re not locked into a particular rate. If interest rates are climbing or are steady, and a steady payment is important to you, a fixed-rate mortgage may be the way to go.
Best candidates for ARMs
- You’re going to be a short-term homeowner
As mentioned, if you don’t plan to live in your new place long, because you move around a lot for work, or this is just your starter home, an ARM may be right for you. Depending on the type of ARM you choose, the fixed-rate period could be anywhere from one to 10 years, and you may plan on leaving the home before rates have a chance to rise. So, if you know this isn’t going to be your forever home, an ARM may make the most sense for you.
If you have the chance to take a 5-year ARM with an interest rate of 4.5% vs a 30-year fixed-rate mortgage with an interest rate of 5.5%, you’re going to save a lot of money on interest.
- You have significant income spikes coming
For people who can expect to see an increase in their income, going with an ARM could save a lot of money on interest in the long run.
If you are just starting your career, you may know that what you make now is going to be significantly higher in a couple years by comparison. Maybe you just graduated from medical or law school — your earning power should grow significantly in the coming years, making an ARM’s potential increased payment affordable.
Or, perhaps you expect to start receiving money from a trust at a certain age. If you could get an ARM that resets in the same year, you might be making the best choice.
- You’re the type who can pay-it-off
Though it won’t pertain to everyone, you might be lucky enough to have the funds to pay off an adjustable-rate mortgage loan early, in just a handful of years, before the new rate even kicks in. If you’re interested in this option, just ensure that you have an ARM loan that allows you to pay it off early, and without any additional fees.
This could be your situation if you’re a homebuyer who’s also selling a home. Let’s say you make your new home purchase, but you’re still locked in a mortgage loan with the old one. Once your previous home sells, you can apply the proceeds to your ARM and potentially pay it off.
ARMs recast when adjusting so if large principal payments are made, it also brings the payment lower upon recast, even if the rate is adjusting higher. If you have a fixed rate mortgage, you may not have that option or may only have it once.
They’re all attractive options! Just remember that life can be risky and unpredictable. If you need your employment to make accelerated ARM payments, and lose your job, become ill, or have other unexpected life events or expenses, it may cause the monthly payment to be hard to meet.
The bottom line
Whatever loan product you’re interested in, your Homespire mortgage loan officer has you covered and can help you choose the best possible product for your situation. They can be your guide to knowing if an ARM is really the best product for you, or if another product is better suited for your lifestyle and financial situation.
When you’re ready to investigate more loan products, Homespire can help. Until then, why don’t you treat yourself to an action-packed movie thriller…The Fugitive, perhaps?
This is not an offer for a loan or any type of extension. Eligibility for a loan or extension of credit from Homespire Mortgage Corporation is subject to completion of a loan application, credit, income, and employment qualification, and meeting established underwriting criteria. Rates are subject to change without notice based on market conditions. See Loan Consultant for information on program income limits, buyer contribution, area median income, debt requirements, and other application details.