An adjustable-rate mortgage (ARM) is one whose interest rate resets after a certain period of time, based on a specified index. ARMs may appear attractive to borrowers because their initial interest rates are lower than fixed-rate mortgages of the same duration. However, the reset options of ARMs could cause borrowers to pay more interest over the life of the loan, depending on the movement of the underlying index. If you’re interested in an adjustable-rate mortgage, you should carefully review the terms of the loan and understand all contracted stipulations.
How is the adjustable rate determined?
Adjustable-rate mortgages usually offer initial rates below the current fixed interest rate. At some point — such as in one year, five years or longer — the rate will reset, based on a specified index and margin. According to the Federal Reserve System, the index is a measurement of market interest rates, such as LIBOR (the London Interbank Offer Rate) or the 1-year U.S. Treasury rates. The margin is the amount over the index you are charged, such as 2 percentage points. As of the date an adjustable rate resets, if the index is 5 percent and your margin is 2 percent, then your new interest rate would be 7 percent. Also note that some adjustable-rate mortgages have rate caps and payment caps to limit increases in your monthly payment. Other adjustable-rate mortgages do not adjust downward, so you may not be able to take advantage of favorable movements in the index.
Calculating adjustable-rate mortgage payments
Before you commit to an adjustable-rate mortgage, you should understand how much your monthly payment will be and compare the amount to a fixed-rate mortgage using a mortgage calculator. Read all of the terms carefully. If you think you might want to pay off your mortgage early, ask your lender about prepayment penalties. In the event of an interest rate reset, know your worst-case scenario and ensure that you will still be able to cover the payments.
Why choose an ARM?
An adjustable-rate mortgage may not be the best choice for everyone, but in certain situations it can be preferable. First, if you are planning to move before the interest rate resets, you will be able to take advantage of a lower rate relative to a fixed-rate mortgage. Second, you may expect your income to increase in the future. If the current adjustable interest rate enables you to purchase a home and avoids the need for you to move again in the future, even with the possibility of an increased payment, then you may decide to go with an ARM.
An adjustable-rate mortgage can be a great fit for certain borrowers willing and able to shoulder the risk. To learn more about the different mortgage offerings, talk to a qualified mortgage lender today.
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