What Is an Adjustable-Rate Loan? Understanding the Basics
An adjustable-rate loan is a home loan that starts with a low fixed-interest rate for a period of time, followed by periodic rate adjustments.
Learn more about the basics of an adjustable-rate loan and the ways in which you can leverage today’s great mortgage rates to attain your new home.
What Is an Adjustable-Rate Mortgage (ARM) Loan?
An adjustable-rate mortgage (ARM) is a loan with an interest rate that will change based on market conditions throughout the life of the mortgage. An ARM loan’s initial interest rate is fixed for a specified period of time at the beginning of the loan term and adjusts for the remainder of the term.
With an ARM, the rate changes periodically, usually in relation to a financial index, and the payments can go up or down depending on how the index performs. All ARMs have some common features. They are the adjustment period, the index, the margin, the note rate, the initial rate, interest rate caps, and payment caps.
How Does an Adjustable-Rate Mortgage Work?
ARM loans come with two different periods: the fixed period, and the adjustable period.
Fixed Period: At the start of an ARM loan, there’s an initial fixed-rate period in which the interest rate doesn’t change.
Adjustment Period: After the fixed period, there’s a period in which your interest rate goes up or down based on changes in the index.
ARM Rate Caps
Once the fixed period ends, the new rate is determined by adding the index to the margin. Margin is a percentage point predetermined by lenders that stays the same throughout the remainder of the loan. Though this may cause the interest rate to increase, adjustable interest rate caps limit how much it can increase.
Initial Adjustment Cap: This is the maximum amount that the interest rate of an ARM loan can increase the first time it’s scheduled to be adjusted.
Periodic Interest-Rate Cap: This refers to the maximum interest rate adjustment allowed between adjustment periods.
Lifetime Cap: This refers to the maximum interest rate allowable for the life of an adjustable-rate mortgage.
Typical ARM cap structure is presented as three numbers representing the above three caps. For example, a rate cap of 5/2/5 on a 5/6 ARM loan means:
Initial Adjustment Cap: The initial interest rate can only change by up to 5% the first time it’s adjusted.
Periodic Interest-Rate Cap: Every change after that is limited to 2% every 6 months.
Lifetime Cap: For the remainder of the loan term, an interest rate can increase or decrease only 5% from the fixed rate.
Types of ARM Loans
A 5/1 ARM loan offers a fixed interest rate for the first 5 years of a loan term. With a 5/1 ARM, the interest rate adjusts once a year for the remaining 25 years.
A 5/6 ARM loan offers a fixed interest rate for the first 5 years of a loan term. After that, the interest rate adjusts biannually (every 6 months) over the remaining 25 years.
A 10/1 ARM loan offers a fixed interest rate for the first 10 years of a loan term. After that, the interest rate is adjusted annually for the remaining 25 years.
A 10/6 ARM loan offers a fixed interest rate for the first 10 years of a loan term. After that, the interest rate is adjusted biannually for the remaining 20 years.
A 7/1 ARM loan offers a fixed interest rate for the first 7 years of a loan term. After that, the interest rate is adjusted annually for the remaining 23 years.
A 7/6 ARM loan offers a fixed interest rate for the first 7 years of a loan term. After that, the interest rate is adjusted biannually for the remaining 23 years.
Fixed- vs. Adjustable-Rate Mortgage Loans
Deciding whether to opt for a fixed-rate or an adjustable-rate loan can sound confusing. An adjustable-rate mortgage differs from a fixed-rate mortgage in a lot of ways. Most importantly, with a fixed-rate mortgage, the interest rate remains the same during the life of the loan.
Fixed-Rate Mortgage Loans
Fixed-Rate loans are the most popular type of mortgage loan because the loan charges a fixed interest rate that remains unchanged throughout the life of a loan term. The amount of principal and interest paid each month varies from payment to payment, though the total payment remains the same.
Most companies offer fixed-rate mortgages in terms of 15 or 30-years, however, you can ask for alternatives such as 10 or 20-year terms. The longer the term, the higher the interest rate, though payment is generally lower due to the payback being spread out over time.
Adjustable-Rate Mortgage Loans
ARM loans charge a fixed interest rate that remains unchanged for a specified period of time during a loan term. After that period of time, the interest rate is adjusted annually or biannually, depending on the type of ARM loan chosen.
With ARM loans, the interest rate changes periodically in relation to a financial index, with payments going up or down depending on performance.
What Are the Benefits of an ARM Loan?
The main benefits of an ARM loan are the low initial interest rate and low upfront payments. These allow for more flexibility in budget and give potential homebuyers the opportunity to purchase a home at a higher market price or provide a lower down payment. Homebuyers also have rate lock options for up to 10 years if they don’t plan on paying off a mortgage.
See if You Qualify
Buying a home is one of the largest financial decisions you’ll make in your life. The choice of whether an adjustable-rate mortgage loan is right for you or not is a significant one.
Ready to buy a home? Looking for an adjustable-rate loan in Sacramento? Get started on securing an adjustable-rate mortgage loan with United Wholesale Lending today.
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