Understanding Adjustable-Rate Mortgages: A Comprehensive Guide
Adjustable-rate mortgages (ARMs) are gaining renewed interest among homebuyers seeking more affordable options in the face of rising home prices and interest rates. At O1ne Mortgage, we are committed to helping you navigate the complexities of mortgage options to find the best fit for your financial situation. Call us at 213-732-3074 for personalized mortgage services.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage is a type of home loan with an interest rate that fluctuates over the life of the loan. ARMs start with a fixed-rate period, typically ranging from six months to 10 years, but most commonly three, five, or ten years. During this initial period, the interest rate is generally lower than that of a comparable fixed-rate mortgage. After the fixed-rate period ends, the ARM switches to a variable rate for the remainder of the loan term, known as the adjustment period.
The most common type of ARM is the 5/1 ARM, where the “5/1” indicates a five-year fixed-rate period followed by annual adjustments. Similarly, a 5/6 ARM has a five-year fixed-rate period with adjustments every six months. These adjustments are based on benchmarks like the one-year Treasury bill or the Secured Overnight Financing Rate (SOFR). When your mortgage adjusts, your payment may increase or decrease based on the new rate.
Pros of an Adjustable-Rate Mortgage
Lower Initial Payments
ARMs typically offer lower interest rates during the fixed-interest period compared to 30-year fixed-rate mortgages. Over the past 15 years, these rates have been about 0.5 to 1.5 percentage points lower, resulting in lower initial mortgage payments and making homebuying more affordable.
Flexibility for Short-Term Borrowers
If you plan to keep your property for only a few years, an ARM can help you save on borrowing costs before you sell. However, be cautious of prepayment penalties that some lenders impose, which could offset any savings. Additionally, a downturn in the housing market could make it harder to sell your home.
Potential for Lower Interest Rates
Since ARM rates are tied to an index, they can adjust periodically. While it’s wise to prepare for higher payments, there’s also a chance that rates could drop, making your mortgage more affordable over time.
Cons of an Adjustable-Rate Mortgage
Potential for Increased Monthly Payments
Although ARMs come with interest rate adjustment caps, your mortgage rate and monthly payments can still increase. If you’re not prepared, higher payments could strain your budget and make it difficult to manage other expenses.
Higher Down Payment Requirements
The minimum down payment for a conventional ARM is typically higher than for other types of mortgages. While some fixed-rate mortgages require as little as a 5% down payment, government-backed mortgages like FHA ARMs may require only 3.5%, and VA ARMs may not require a down payment at all.
Costly Refinancing
Refinancing an ARM to a fixed-rate mortgage can be expensive, with closing costs potentially running into the tens of thousands of dollars. This strategy may save you money over time, but it’s essential to consider the upfront costs.
Adjustable-Rate Mortgage vs. Fixed-Rate Mortgage
When comparing an ARM with a fixed-rate mortgage, it’s crucial to do the math. For example, if you’re buying a $500,000 home with a 20% down payment, you need a $400,000 mortgage. Comparing a 30-year fixed-rate loan at 7.18% with a 5/1 ARM at 6.20%, the ARM offers lower initial payments but could become more expensive if rates rise significantly.
During the initial fixed-rate period, you would save $260 each month with the ARM, translating to a five-year savings of $15,600. However, if the ARM rate rises by 0.97% or more, the fixed-rate loan could become the cheaper option in the long run.
Is an ARM a Good Idea?
An ARM can be a good option if you plan to sell your home before the interest rate resets. The initial fixed-rate period offers predictability, and there’s a chance that rates won’t increase significantly. However, if you prefer stability and predictability, a fixed-rate mortgage may be a better choice.
Should You Refinance an ARM to a Fixed-Rate Mortgage?
If you choose an ARM, you can refinance to a fixed-rate loan after the initial rate expires. However, refinancing comes with closing costs and fees, which can range from 2% to 6% of the loan amount. If you plan to keep your property long-term, locking in a new rate could reduce your risk and provide peace of mind.
Good Credit Can Help You Obtain a Low Mortgage Rate
Having good or excellent credit can help you secure a lower mortgage rate, whether you choose an ARM or a fixed-rate mortgage. Check your credit report and score to understand where you stand and take steps to improve your credit if necessary.
At O1ne Mortgage, we are here to help you navigate your mortgage options and find the best fit for your needs. Call us at 213-732-3074 for expert advice and personalized service. Let us help you make your homebuying journey as smooth and affordable as possible.
