An adjustable-rate mortgage (ARM) is a type of mortgage loan in which the interest rate may change periodically over the life of the loan.
Let’s dive deeper into adjustable-rate mortgages, so you understand how they work, their purpose, and why a buyer might choose this type over a fixed mortgage.
Understanding the Adjustable-Rate Mortgage
When a borrower makes regular monthly payments to their lender, their monthly payment goes toward both the principal of the loan and the interest. The interest is the cost of borrowing money and is based on the loan’s interest rate.
When a buyer chooses an adjustable-rate mortgage, they must understand that the interest rate may adjust periodically, which could lead to higher monthly payments.
How Does an Adjustable-Rate Mortgage Work?
Adjustable-rate mortgages usually have an initial fixed-rate period of a few months or several years, during which the interest rate remains constant.
However, once that initial period ends, the interest rate may adjust periodically, often annually.
It’s worth noting that the interest adjustments are usually subject to caps. Caps limit how much the interest rate can change during a specific period and over the life of the loan.
What is the Purpose of an Adjustable-Rate Mortgage?
Borrowers may choose an ARM if they expect interest rates to remain stable or decline, as the initial fixed-rate period often comes with a lower interest rate than fixed-rate mortgages.
However, the future is uncertain. And some homeowners end up paying more for their loans when interest rates climb.
How Do You Apply for an Adjustable-Rate Mortgage?
Most homebuyers begin the process by getting pre-approved by a lender. During this process, the lender will assess the borrower’s financial information and provide a pre-approval letter indicating the borrower’s maximum loan amount.
Once the buyer has found a property, they submit a formal loan application with the lender. This requires the borrower to provide detailed financial information.
Before the loan goes through, the lender typically requires a professional appraisal of the property to ensure its value supports the amount of the loan.
If the loan is approved, the buyer will review and sign the necessary documents, including the adjustable-rate mortgage disclosure. This disclosure ensures the buyer understands the terms of the loan.
What Documents Do I Need for an Adjustable-Rate Mortgage?
Here are some of the documents a homebuyer may need for an adjustable-rate mortgage:
- Proof of identity
- Proof of income (pay stubs, W-2 forms, tax returns, 1099 forms)
- Employment verification
- Proof of assets (bank statements, investment statements, or gift letters)
- Credit history report authorization
- Debt information
- Property information (purchase agreement, property information)
- Proof of homeowners insurance
Consult with your lender regarding the specific documents they require.
What Are the Types of Adjustable-Rate Mortgages?
Borrowers should talk with their lending institution to learn more about the current types of adjustable-rate mortgages. Here are some types, along with a brief description of how each works.
1. Hybrid adjustable-rate mortgage
These ARMs have an initial fixed-rate period, during which the interest rate remains constant. After the initial period, the rate adjusts periodically based on a specified index, such as the U.S. Treasury Bill rate.
2. 3/1 ARM, 5/1 ARM, etc.
The first number in this type of ARM represents the initial fixed-rate period (such as three or five years). The second number indicates how often the rate adjusts annually.
3. Interest-only ARM
During the initial period, borrowers pay only the interest on the loan, not the principal. After the interest-only period, the loan converts to a fully amortized loan, which means the payments go to both the principal and interest.
4. Payment option ARMs
These ARMs offer multiple payment options, including a minimum payment, an interest-only payment, and a full payment that goes toward the principal and interest.
5. Convertible ARMs
With this ARM, borrowers can convert their adjustable-rate mortgage to one with a fixed rate – at specified times or under certain conditions.
6. Two-step mortgages
A two-step mortgage combines the features of a fixed and adjustable-rate mortgage. Borrowers have an initial fixed-rate period, followed by a longer adjustable-rate period.
7. Capped rate ARM
These ARMs have a maximum limit on how much the interest rate can increase over the life of the loan, providing some protection against significant rate hikes.
Pros and Cons of Adjustable-Rate Mortgages
Adjustable-rate mortgages have advantages and disadvantages. Borrowers should consider their unique financial situation, risk tolerance, and plans when deciding whether an ARM is the right choice for them.
Here are some general pros and cons to consider.
Benefits of adjustable-rate mortgages
- Lower initial interest rate
- Potential for lower total interest costs
- Initial fixed-rate period
- Offers flexibility for short-term homeownership
- Can be converted to a fixed-rate mortgage under certain conditions
Drawbacks of adjustable-rate mortgages
- Potential for rate increases, which will increase your monthly payment
- Monthly payments may increase significantly
- World economic factors and market conditions can impact the borrower’s interest rates
- More complex to understand
Before choosing an ARM, borrowers should carefully consider their financial goals, plans, and ability to manage a potential payment increase.
After you become a real estate agent, you are not expected to give financial advice to your clients. However, you may be asked to define terms and direct borrowers to lenders in your area.
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