What is an Adjustable-Rate Mortgage?

Real Estate

Aug 4

Part of being a homeowner is determining which home financing solution works best to help you achieve your financial goals. But with so many choices, determining the right type of home financing can be a bit challenging.

One home mortgage solution that both new and experienced homeowners often overlook is adjustable-rate mortgages. Adjustable-rate mortgages (ARM) have historically received a bad reputation for their popularity leading up to the 2007-08 financial crisis.

But don’t let their reputation fool you. Adjustable-rate mortgage loans can be advantageous if used in the right manner. Recently, adjustable-rate mortgage originations hit the highest level they have been at in over a decade, making up 11% of all home loans (WTSP).

While an adjustable-rate mortgage might not be the best home mortgage option for every borrower, it can still provide tremendous upside for certain households. Let’s take a deeper dive into how an adjustable-rate mortgage works and why you might consider using one.

How Does an Adjustable-Rate Mortgage Work?

An adjustable-rate mortgage (ARM), sometimes referred to as a variable-rate mortgage, is a type of home loan where your interest rate is subject to change over the life of the loan.

The interest rate on an adjustable-rate mortgage adjusts based on changes in the market. But before you get discouraged, thinking your payment will change right out of the gate, understand that ARMs have both a fixed-rate and adjustable-rate component to them.

Typically, an adjustable-rate mortgage will start with an initial fixed rate or introductory period. This period can last anywhere from 3-10 years depending on how your loan is structured. Within this window, your interest rate will not change.

Once the initial fixed period is over; your mortgage will enter an adjustment period which is the period in which your interest rate can go up or down.

The frequency at which your rate adjusts will also depend on how your mortgage is set up. In some cases, it could be annually while in others it could be semi-annually.

For example, let's say you take out a new 30-year 5/1 adjustable-rate mortgage. The ‘5’ refers to the number of years in the fixed rate period (5 years).

The ‘1’ refers to how frequently your rate will adjust after the fixed rate period is over, throughout the remaining life of your loan (1 year or annually).

Calculating Your ARM’s Interest Rate

The interest rate you have on an adjustable-rate mortgage can be broken down into two specific components: the index and margin.

The index is a benchmark interest rate derived from general market conditions and is the component that can fluctuate over time (Consumer Finance). Many lenders now use the Secured Overnight Financing Rate (SOFR) as the index on most adjustable-rate mortgages.

The margin is the second component of your interest rate, reflecting a specific percentage added to the index rate for which your lender is charging you (Consumer Finance).

The index and margin will not change once you close on your new mortgage loan. The fully indexed rate refers to when you add the index and margin together.

Understanding Interest-Rate Caps

Keep in mind that there are also caps that lenders must adhere to that govern how much your interest rate can adjust. There is an initial, subsequent, and lifetime cap.

The initial adjustment cap reflects the max your interest rate can increase by the first time it adjusts. Most of the time the cap is between 2% and 5% (Consumer Finance).

The next cap is the subsequent adjustment cap, which governs how much your interest rate can adjust on all other adjustments following the first. The amount for this cap is normally 2% (Consumer Finance).

Lastly, there is a lifetime adjustment cap which dictates the max amount your interest rate can adjust over the total life of your loan. This amount can fluctuate but is often around 5% (Consumer Finance).

Pros and Cons of Adjustable-Rate Mortgages

Pros to Using ARM

Adjustable-rate mortgages are starting to gain favor once more, especially in the wake of recent rate hikes. For one, they allow you to have a smaller monthly payment for a period. Also, should rates slide downward, ARMs let you benefit from those declines during your adjustment period.

Another reason why choosing an ARM could be beneficial is that they offer great flexibility depending on what your financial goals are. There are a variety of ways to structure an adjustable-rate mortgage and they can often be a great short-term financing option.

For example, if you know you plan to move or sell your house over a shorter time horizon then an ARM is a great tool to use because it allows you to pay less money in the short term. You won’t have to worry about the adjustment period because you will have already moved or sold your home.

Cons to Using ARM

Nevertheless, no home mortgage solution is without its flaws. While there are certain advantages an adjustable-rate mortgage can provide, there can also be some disadvantages.

To start, the obvious risk is that your interest rate has the potential to increase over time once your loan hits the adjustable period. This means your payment can go up and the total amount you pay in interest over the life of your loan could increase.

Also keep in mind that while you might intend to only have our ARM for a few years, life may throw you a curveball. You may be stuck in a situation where you cannot sell or refinance, resulting in you paying more for your mortgage, or worse losing your home.

Lastly, adjustable-rate mortgages are much more complex than other fixed-rate forward mortgage options. They have different rules and can be structured in a variety of ways. While this is great for flexibility, it also means you need to fully understand all the repayment terms before you commit to an adjustable-rate loan.

Conclusion

Adjustable-rate mortgages are often overlooked but a valuable arrow in any new or existing homeowners quiver when reviewing your mortgage financing options. In fact, adjustable-rate mortgages are starting to make a comeback.

Borrowers are starting to understand the tremendous upside adjustable-rate mortgages can provide whether it be smaller payments during the fixed period or the value of potentially seeing your interest rate go down.

Nevertheless, adjustable-rate mortgages are not without risk. Keep in mind they can be complex and have the option to become less affordable if interest rates head higher.

No matter what home loan you decide to go with, the choice is up to you. Whether or not you choose to use an adjustable-rate mortgage or not, Doorvest will support you along the way. Our partners, Catlex and Beeline, are looking to offer these options soon.

If you are searching for more variety, check out our list of non-traditional ways to finance an investment property. In any scenario, Doorvest's Client Partners are here to help you decide on the purchasing choices that work best for you. You can contact them at clientpartners@doorvest.com, or schedule a call to get your questions answered instantly.