ADJUSTABLE RATE MORTGAGE
What is an Adjustable-Rate Mortgage (ARM)?
If you are a homebuyer who would like more space for change in your mortgage, an Adjustable-Rate mortgage (ARM) might be the right choice for you. If you are planning to change homes in a few years or you believe that interest rates will be lower in the years after you purchase your loan, then you might benefit from an ARM. An ARM is a variable-rate mortgage. This mean that the interest rate changes according to the market. Unlike a Fixed-Rate mortgage, ARM rates adjust to the market after a set period of time agreed upon by you and your lender.
Adjustable-Rate Mortgage Overview
A mortgage rate is the interest rate you pay on your mortgage loan. Mortgage rates change daily and are based on fluctuations in the market. An ARM has an interest rate that can periodically adjust based on the terms of the loan. The two numbers commonly seen with ARM loans, like a 5/1 ARM, signifies both the number of years your rate will remain the same and how often it will adjust after the introductory period.
In the 5/1 example, the interest rate that you started with will stay the same for five years. Then, once that time period is over, the rate will adjust once a year to a new rate. Since the initial interest rates and payments are often lower than Fixed-Rate mortgages, many borrowers choose an
ARM option as they offer savings up front.
When the fixed period is over and your rate adjusts, interest rate changes are capped.
How Does an Adjustable-Rate Mortgage Work?
An ARM works like most home loans. Once you have determined your homeownership goals and financial capabilities, you’ll start researching which mortgage will suit your needs. ARMs can be beneficial for people who are planning to move soon and don’t want a long-term mortgage.
You and your lender will agree on a certain set of terms and conditions for your individual loan. These include your monthly payment amount, the interest rate of your loan, and other logistical guidelines. The terms and conditions of your loan depend on several applicable factors. These can include, your credit score, your current debt-to-income ratio (DTI), your monthly income, and the current housing market.
DTI is the total sum of the monthly payments you make towards your current debt divided by your monthly income. This debt can include credit cards, student loans, car notes, or other loans. Lower DTI and higher credit scores signal to your lender that you are more likely to pay off the entirety of your home loan. That is why having a higher credit score and lower DTI can sometimes get you lower rates on your loan.
For an ARM, these terms and conditions will change over the life of the loan. The monthly payments you make at the beginning of the loan will be different than the monthly payments you are making at the end. This is because ARM loans are adjustable. It is important with ARMs to note that interest rates fluctuate. This means that when the terms of your loan change, the amount you’re paying could decrease or increase depending on the current rates.
Adjustable-Rate Mortgage Benefits
ARMs have many benefits.
Upfront savings: With the lower rate and payment in the initial period, you’re free to reach your financial goals with the money you would be using on a fixed-rate loan
Initial fixed period: Enjoy the fixed, lower rate for the initial period
Interest Caps: You won’t be taken by surprise because there are limits on the adjustment. Adjustable-Rate mortgages typically have rate caps built into them limiting how high the rate can be. A periodic rate cap will limit how drastically the interest range can increase from one year to the next. Lifetime rate caps similarly limit how much the interest rate can go up during the life of the loan.
ARMs may be particularly beneficial for borrowers in certain circumstances.
Homeowners who move frequently
Workers expecting to earn more income in the next few years
Purchasers who renovate and resell properties
Borrowers who plan to refinance before the loan adjusts
Family planners hoping to upscale to a larger house in the near future
ARM Loan Requirements
Each mortgage lender has their own individual qualification standards when issuing a loan. Make sure to check with your lender to find out the specific requirements for approval for your loan.
Here are some general requirements to qualify for a ARM.
A minimum credit score of 580 to 620: Having a good credit score is the main way borrowers are able to qualify for the lowest mortgage rates. Lenders generally consider a good credit score to be between 670 and 739. A credit score of 620 is the minimum required to qualify for a standard Conventional loan. Some lenders may accept as low a score as 500 for other ARMs such as FHA.
A maximum debt-to-income ratio of 50%: Having a low DTI is also important in finding low mortgage rates. Lenders want to make sure you are capable of repaying your debts. If your DTI exceeds 43%, it could be difficult to qualify for a mortgage.
The ability to pay at least a 3% down payment: The exact amount of down payment required will depend on the loan type and the terms and conditions of your individual loan.
If you're looking to refinance your mortgage with an ARM, you will need these things in addition to the previous requirements.
Proof of Income: Show evidence of steady and consistent income – this can include W2s, tax statements, or check stubs
Asset Information: Statements for all bank and credit accounts, 401k, and other investment records to show any additional income and assets
Homeowners Insurance: Be able to prove to your lender that you have the necessary coverage for your property
In addition to general requirements, your lender will also have their own individual set of qualifications for refinancing.
Adjustable-Rate Mortgage Rates
After the initial fixed-rate period is over the interest rate on the ARM will change. The interest rate is determined by adding the index and the margin.
The index is: A variable interest rate the ARM is tied to that reflects market conditions. For example, it can be the Prime Rate or the rate on the U.S. Treasury bills.
The margin is: The fixed percentage points a lender adds to the index to which the ARM is tied. The index can change, the margin, however, remains the same.
The interest rate a person receives on an ARM is dependent on their credit profile and other factors, and is likely different for each person.
A loan that may be available for multiple properties
Fixed Vs. Adjustable-Rate Mortgages
When borrowers begin researching and applying for mortgages, they are given the option of getting a Fixed-Rate mortgage or an Adjustable-Rate mortgage.
A Fixed-Rate mortgage offers borrowers stable and predictable payments. Fixed-Rate mortgages have the same terms and conditions for the life of the loans regardless of fluctuations in the housing market or economy. The payments you make at the beginning of the loan stay the same until the end of the loan. The terms of these loans are straightforward, and they are useful for budgeting since your payments don’t change.
An ARM has an interest rate that can periodically adjust based on the terms of the loan. This often allows borrowers to have lower rates up front. However, since the terms and conditions of the loan do change over time, it offers less stability. These changes will be stated in the original loan agreement. ARMs can be beneficial to borrowers who expect to move in the next few years or who are planning to refinance after the introductory fixed-rate period ends.
Types Of Adjustable-Rate Mortgage Loans
ARMs have two numbers that signify the interest rate terms of that loan.
5/1 and 5/6 ARM: Offers an initial fixed period of five years, then the rate will adjust every year or every six months. The adjustment will be based on predetermined guidelines.
7/1 and 7/6 ARM: Offers an initial fixed period of seven years, then the rate will adjust every year or every six months. The adjustment will be based on predetermined guidelines.
10/1 and 10/6 ARM: Offers an initial fixed period of 10 years, then the rate will adjust every year or every six months. The adjustment will be based on predetermined guidelines.
In addition to the various types of ARMs, there are also the types of loans that can be Fixed-Rate mortgages or ARMs.
Conventional ARM: A Conventional loan is not insured or guaranteed by the government. This means it has fewer limitations and restrictions, which allows lenders some flexibility in the terms and conditions they set for their borrowers. Conventional loans typically require a down payment of as little as 3% of the total cost of the home.
Lenders can offer flexible term lengths on Conventional loans, ranging from 10 to 30 years. Since lenders are at a higher risk with a Conventional loan, the borrower may be required to secure private mortgage insurance (PMI) if they have a down payment of less than 20%.
PMI will no longer be required once a borrower reaches 20% equity in the home.
FHA ARM: An FHA loan is a mortgage insured by the Federal Housing Administration. The FHA is a federal government agency that is part of the Department of Housing and Urban Development. FHA loans are backed by the federal government and are often a valuable option for homebuyers who do not qualify for a Conventional loan.
FHA loan requirements vary depending on individual loan types but require as little as 3.5% down payment on a home purchase. FHA loans may be a valuable option for first-time homebuyers, buyers with a lower credit score, or a challenging credit history.
One thing to consider: FHA loans require both an upfront payment for mortgage insurance and separate monthly mortgage insurance payments for as long as the life of the loan, depending on the loan-to-value ratio.
VA ARM: A VA loan is a mortgage guaranteed by the Department of Veterans Affairs. VA loans are exclusively for active-duty military personnel, veteran service members, and certain military spouses. VA loans carry significant benefits for those that qualify, including lower interest rates, no required down payment, and no monthly mortgage insurance premiums.
How to Qualify for an Adjustable-Rate Mortgage
Qualifying for an ARM is like qualifying for any other loan. You will need a good credit score and low DTI. Each loan type and lender has different applicable requirements to qualify. For instance, an FHA ARM may have lower credit score requirements than a Conventional one.
The qualifications for an ARM are similar to that of a Fixed-Rate mortgage. It depends on the borrower's credit history, income, and more. The main difference is that the monthly payments on an ARM will change over time while the monthly payments on a Fixed-Rate mortgage will remain the same.
A good place to start is by getting pre-approved for the loan. This allows the borrower to know how much they can afford to spend on a home, speeds up the loan process, and allows sellers to know they are searching with intent.
Refinancing an Adjustable-Rate Mortgage
Sometimes a borrower may want to refinance from an ARM to a Fixed-Rate mortgage. This will mean replacing the mortgage they currently have with a new one with a new set of terms and conditions. In order to do this, you will have to go through the same set of steps that you went through to apply for the original mortgage. The requirements will be the same, proof of income, DTI information, and proof of identification. You will also need to pay closing costs on the new loan including relevant fees.
Whether or not you want to make the switch will depend on the current market and your individual needs. Make sure to check with your lender as they will have their own set of requirements for refinancing.
FAQs
Do Adjustable-Rate Mortgages have prepayment penalties?
Adjustable-Rate mortgages can have prepayment penalties, but they don’t always. Check with your lender to find out the conditions of your specific loan agreement.
What is an advantage of an Adjustable-Rate Mortgage?
One of the main advantages of ARM loans is that they offer lower rates up front. This allows you to pay less at the beginning of the loan. Saving this money can help you with other financial goals. Like investing or using the extra money to build equity in your home by paying down your principal faster.
Can I refinance my ARM to a Fixed-Rate Mortgage?
Yes, Adjustable-Rate mortgages can be refinanced. Refinancing an ARM can benefit borrowers who refinance before the interest rate on their ARM adjusts.
What are the ARM Limits?
The 2024 loan limit for an ARM is up to $766,550 for a single-family home. Note that limits may be higher in areas where the home prices are above the national average.
Are There Rate Caps on Adjustable-Rate Mortgages?
Adjustable-Rate mortgages may have rate caps that can limit how high the interest rate can go. These rate caps can affect the initial rate adjustment, periodic rate adjustments, or adjustments over the life of the loan.
What are you waiting for?
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E Mortgage Capital, Inc. is a full-service mortgage company that offers extensive options for residential mortgages, with quick service and leading rates.
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