Most future homeowners start their journey with a mixture of excitement, confusion and maybe even a little fear. While the prospect of owning your own home is absolutely thrilling, the number of choices you have to make can quickly become overwhelming – especially when it comes to what kind of mortgage you should choose.
The best way to get past any anxiety you have as a homebuyer is to explore all of your options and consider your goals (financial and otherwise) before you make any firm decisions. So, let’s talk about ARM loans, and why they could be right or wrong for you.
What Is an Adjustable-Rate Mortgage, Anyhow?
Most people have heard of ARM loans, but not that many people actually understand how they work and why people sometimes choose them.
In essence, ARM loans are mortgages that have an interest rate that changes over time with the market, as opposed to a fixed-rate loan that “locks in” your interest rate for the duration of the loan (unless you choose to refinance).
Why would anybody choose a mortgage loan that doesn’t stay the same rate? Well, it often has to do with the buyer’s overall goals and the current rates of inflation. Consider these scenarios:
1. You Believe That Interest Rates Will Eventually Lower
Right now, for example, ARM loans are attracting a lot of new attention from borrowers precisely because they offer that initial period with a low-interest rate. With inflation on the rise, interest rates have risen dramatically since this time last year – and 2023 isn’t expected to be any better.
Savvy homebuyers are always looking for ways to lower their costs and expand their buying power, and an ARM loan may allow them to do that. If you’re betting that interest rates will cycle back down by the time your introductory period ends, that can make an ARM loan very attractive.
2. You Expect a Positive Change in Your Financial Situation
Another reason to choose an ARM loan is when you’re fairly certain that your personal financial situation will improve well before the introductory period ends on the loan, allowing you to refinance to a fixed-rate loan with a reasonable interest rate or even pay off the home outright.
This can apply to all kinds of situations, but it may be especially relevant to young professionals who are just starting their careers or growing their business. When you know that your career (and income) is on an upward trajectory but you’re on a limited budget right now, an ARM loan can be perfect for your needs.
3. You Intend to Sell the Home Again Before the Initial Period Ends
Some homebuyers are looking for their “forever” home, while others are only looking for a starter home. Some are just looking for a good investment and still others are looking for a comfortable spot to call home for a few years because they know their careers will cause them to soon move on.
That low introductory period that comes with an ARM loan can translate to a lot of savings over the next few years and keep more money in your pocket every month – but you do want to make sure that your plans are pretty solid (or, at least, know that you can afford the new mortgage payment once your interest rate resets if your plans change).
How Does an ARM Loan Work?
Typically, ARM loans have an introductory period with a fixed interest rate – and that interest rate is generally much lower than what borrowers can get through a typical 30-year fixed-rate loan. This initial period can be virtually any length, but periods of three, five and seven years, ten and even 15 years are very common.
As soon as this initial period is up, the interest rate on your mortgage will be adjusted. The typical adjustment will be every six months, and it can go either up or down depending on the financial index being used and the lender’s margin.
The most common financial index used is the SOFR (Secured Overnight Financing Rate). The SOFR is the average rate at which institutions can borrow US dollars overnight while posting US Treasury bonds as collateral. The SOFR is published by the New York Federal Reserve every business day for the previous business day.
Does that mean that your ARM loan can skyrocket? Not if you have a cap structure built into the terms of your loan, which is also common. Caps give borrowers some security when it comes to their mortgages, which can be important if your future plans don’t manifest. Rate caps operate three ways:
- An initial cap limits how much your rate can change when your introductory period ends.
- The periodic cap limits how much the interest rate can go up or down every adjustment period in the future.
- A lifetime cap tells you the maximum your interest rate can change over the lifetime of the loan.
Lenders express both the terms of your interest rate and its caps with a numbered structure, so if you have a 7/6 ARM loan with a 2/2/5 cap that means:
- You have a seven-year introductory interest rate which will then be adjusted bi-annually.
- Your rate cannot rise or fall more than 2% the first time it is recalculated (when your introductory period ends).
- Your rate cannot rise or fall more than 2% each time it is readjusted in the following years.
- The maximum that your interest rate will ever change (for better or worse) is 5% over your introductory rate.
Again, lenders vary considerably, both in the length of introductory periods they will offer to the margins they use and the caps they’ll allow. That makes it particularly important to shop around and make certain that you’re comfortable with all the foreseeable possibilities for the future.
We talk a lot about the different types of mortgages available to you, whether that’s a conventional loan, an FHA loan or something different – because it’s important to consider all your choices carefully. As your local mortgage experts, we want to help future homeowners make an educated decision as they pursue their dreams.