When it comes to purchasing a property, homeowners generally have two choices unless they have enough cash on hand: either to finance a home with a fixed-rate mortgage or an adjustable-rate mortgage (ARM). A fixed-rate mortgage protects borrowers from an unexpected and significant increase in interest rate. If the market has shown, rates can change rapidly thereby affecting the affordability of a property.
A fixed rate mortgage comes with a fixed payment over the lifespan of the loan. Borrowers have to pay a fixed interest rate and payment on a fixed-rate mortgage until they refinance. An adjustable-rate mortgage has a fixed rate for an introductory period, and once the period ends, the interest rate is adjusted according to the specifics of the loan which can either be that the rate goes up to an agreed upon rate or increase to a newer higher rate based on the current market rates . Although adjustable-rate mortgages are risky since the rate is not fixed and it can rise and fall significantly, they have some striking advantages that attract homeowners to choose them over fixed-rate mortgages.
In this article, we will discuss some major advantages of adjustable-rate mortgages, but before we move further, let’s see what an adjustable-rate mortgage is and what its key features are.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage is a type of mortgage with fluctuating rates. The interest rate starts with a low rate as compared to a fixed mortgage. The introductory rate is fixed and then starts fluctuating with the end of the introductory period. The interest rate will likely increase or decrease depending on the market situation, and so will your monthly payment.
ARM programs can be greatly beneficial for short term property owners such as those wanting to buy and sell in the near future or for those wanting to buy, fix and flip. Having a lower rate can prove invaluable when profits are the forefront of the borrower’s goals. If borrowers get an adjustable rate mortgage, they must be aware of the inherent risk of their rate increasing in the near future. If rates are at or near historic lows, it is advised to get a fixed rate to avoid the chance their new rate is unaffordable. If however, rates are high, and it could be expected that rates may decrease overtime, an adjustable rate mortgage may be a good option.
Key features of an adjustable-rate mortgage (ARM)
The three most important features of an adjustable-rate mortgage are:
- Introductory rate
- Actual rate
- Conversion option
Adjustable-rate mortgages start with a teaser rate (a low and fixed interest rate) for an introductory period, ranging from 3 to 10 years. The introductory rate offered by the lender is below their prime rate for a fixed time. With the conclusion of the introductory period, the interest rate is adjusted according to the market conditions. The introductory rate will change and adjust to the index rate, referred to as the actual rate. Once the rate adjustment period starts, many lenders allow borrowers to convert their adjustable rate mortgage into a fixed-rate mortgage by paying some additional fees.
One reason why homeowners avoid adjustable-rate mortgages is because of the unpredictable interest rate after the introductory period. Homeowners consider adjustable-rate mortgages (ARM) risky, but their benefits outweigh their risks, if done at the proper time in the market. Let’s find out the advantages of ARM.
The benefit of an adjustable-rate mortgage
Choosing an adjustable-rate mortgage over a fixed rate can prove to be a solid financial decision, especially when homeowners know that they will be relocating in the near future or will pay off their loan soon. You may be able to save a substantial amount of money on interest throughout the loan life.
Here are some of the advantages of an adjustable-rate mortgage:
- Introductory rates are lower and fixed: The first and foremost benefit of choosing adjustable-rate mortgages is the lower introductory rates. Adjustable-rate mortgages begin with a lower rate than any fixed rate program. You can save the hard-earned money that you would have paid on interest. Since you borrow a huge amount of money, even a minor reduction in the interest rate could save you thousands of dollars over the life of the loan.
Even if your introductory period ends and rates increase significantly, refinancing will help you get a better rate. This feature of an adjustable mortgage rate attracts homeowners the most.
- Qualifying for an adjustable-rate mortgage is easier: A lower interest rate makes the monthly payment more affordable. Even if you are already in debt, qualifying for an adjustable-rate mortgage is easier than its fixed counterpart.
One of the determining factors in the loan approval process is your debt-to-income (DTI) ratio. The lower the interest rate is, the lower monthly payments will be, and this, in turn, leads to lower DTI. If your DTI ratio is lower, you can eliminate a hurdle in the way of loan approval. Therefore, because arm programs have lower rates and lower payments, a borrower’s DTI ratio would likely be lower allowing more borrowers to qualify.
- Payment caps protect borrowers: Once your introductory period ends, the interest rate can be increased significantly, and so will your monthly payment. Adjustable-rate mortgages protect borrowers with payment caps that limit how much the rate can be increased. Borrowers can have a cap on the interest rate or monthly payment. Prior to agreeing to use an adjustable rate mortgage, it is very important to be aware of the payment cap.
An adjustable-rate mortgage is a popular product among homeowners. The lower interest rate of the introductory period helps save thousands of dollars in interest throughout the loan life. It can prove to be more beneficial if you are going to live in the house only for a few years and later sell it prior to the interest being adjusted. If you sell before the adjusted rate starts, you won’t have to deal with unpredictable rates, and will save thousands in interest. This can prove valuable to short term property owners and those looking to maximize profits.