For those searching to buy or refinance their current mortgage, adjustable rate mortgages (ARMs) are a viable option. An ARM is a type of loan with an interest rate that may fluctuate over time based on an index. While an ARM usually has lower monthly payments than fixed-rate mortgages, they come with increased risk as the interest rate could rise in the future.
This article will take a closer look at adjustable rate mortgages (ARMs), their workings, the pros and cons, as well as current ARM rates.
How Adjustable Rate Mortgages Work
Adjustable rate mortgages offer you the ability to lock in an adjustable rate for life. Here’s how:
An adjustable rate mortgage (ARM) is a type of mortgage with an interest rate that can fluctuate over time. ARMs are based on indexes, which serve as benchmarks for reflecting the economy’s state. Common indexes used for ARMs include London Interbank Offered Rate (LIBOR), Cost of Funds Index (COFI), and Treasury Bill Index.
When taking out an ARM, your interest rate will typically remain fixed for a set period of time – such as five or seven years – known as the initial rate period. After this initial rate period ends, however, your ARM’s interest rate can adjust up or down depending on factors like inflation and other market fluctuations.
Most ARMs feature caps, which restrict how much an interest rate can adjust in any given period. For instance, a typical ARM might have an annual cap of 2% which means that its interest rate can only rise or fall by a maximum of 2% each year.
Advantages of an Adjustable Rate Mortgage
An adjustable rate mortgage (ARM) offers the primary advantage of offering a lower interest rate than fixed-rate mortgages, making the monthly payments on an ARM more manageable for homebuyers who are just starting out or with limited budgets.
Another advantage of an ARM is that it may be a suitable option for those planning to sell or refinance their mortgage soon. If you only plan to remain in your home for a few years, an ARM with a lower interest rate during its initial rate period could save money in the short-term.
Disadvantages of an Adjustable Rate Mortgage
An adjustable rate mortgage has several distinct advantages that must be considered before signing on the dotted line.
One of the primary drawbacks of an adjustable rate mortgage is that its interest rate can fluctuate over time, making it difficult to budget for your monthly mortgage payment. If rates rise significantly, your payments could go up significantly; this could prove challenging if you have a fixed income or tight financial restrictions.
Another downside of an ARM is that it can be riskier than a fixed-rate mortgage, as you are betting against interest rates rising significantly during the course of your loan. If rates do rise significantly, however, you could end up paying more in total interest over its duration than with a fixed rate mortgage.
Current ARM Rates
As of March 17, 2023, the following are the current ARM rates for 30-year, 15-year and 10-year fixed rate mortgages:
- 30-Year Fixed Rate: 6.97%
- 15-Year Fixed Rate: 6.21%
- 10-Year Fixed Mortgage: 6.27%
- It is essential to remember that interest rates can change over time due to economic conditions and other variables. Before making a decision about an ARM, research current rates and compare them with fixed-rate mortgages to determine which option best meets your requirements.
Adjustable Rate Mortgage: Examples and Statistics
To better comprehend how adjustable rate mortgages function, let us look at some examples and statistics.
Consider a 5/1 ARM with a 2% annual cap, 5-year initial rate period and index based on LIBOR. Assume your initial interest rate on this ARM is 4%; this means for the first five years of your mortgage your rate will remain fixed at that level for five years.
Once the initial rate period ends, your adjustable-rate mortgage (ARM) interest rate can adjust up or down according to various factors like the index. For instance, if at the end of five years your ARM’s initial rate period ends and the index drops to 3%, then your interest rate will adjust up to 5%; that is equal to 4% plus an annual cap of 2%.
If the index stays at 3% for another year, your interest rate will remain at 5%. However, if it increases to 4%, your rate adjusts up to 6% (which is equal to both the initial rate of 4% plus an annual cap of 2%). Conversely, if it decreases back down to 2%, then you would see your interest rate return to its original level of 4%.
Example 2: Compare Fixed-Rate Mortgage and Adjustable-Rate Mortgage
Consider a $300,000 mortgage with a 30-year term and 6.5% interest rate. With this type of fixed-rate mortgage, your monthly payment would be $1,896.20.
However, if you select an ARM with a 5-year initial rate period, 2% annual cap and 4.5% initial interest rate, your monthly payment would be $1,520.06 for the first 5 years. After this initial period ends, however, your interest rate could adjust up or down depending on factors like inflation and other market fluctuations.
If interest rates remain stable throughout the life of your mortgage, an ARM could save you money. On the contrary, if rates rise significantly, your monthly payment could go up significantly, making budget management more challenging.
According to the Mortgage Bankers Association, adjustable rate mortgages accounted for 7.1% of all mortgage applications during the week ending March 11, 2023 – an increase from 6.6% the previous week.
Historically, adjustable rate mortgages have been more popular during periods of low interest rates as they offer a lower initial interest rate than fixed-rate mortgages. However, as interest rates rise, more homebuyers may choose to secure fixed-rate mortgages in order to protect themselves against increases in rates.
Adjustable rate mortgages (ARMs) can be an attractive option for homebuyers seeking a lower initial interest rate or who plan to sell or refinance their mortgage in the near future. However, an ARM may carry greater risk than fixed-rate mortgages, since interest rates may fluctuate over time.
When considering an adjustable rate mortgage, it’s essential to research current ARM rates and compare them with fixed-rate mortgages in order to decide which option best meets your needs. Furthermore, take into account your long-term financial objectives as well as how well you can handle changes in your monthly mortgage payment.