When you start the mortgage shopping process, there are plenty of different loan options to decide between. That can lead to questions about whether you only focus on fixed-rate mortgages, or whether an adjustable-rate loan is a wise choice during the current economic climate. So are ARM loans a good idea?
ARM loans can be a great way to save money, as ARM mortgage rates can start out lower than fixed-rate mortgages. However, there are plenty of pros and cons to this type of loan. Research and careful consideration are vital to ensure you are picking the best possible mortgage deal for you.
What is an ARM loan?
An ARM loan or adjustable-rate mortgage is a type of mortgage that starts with a period of fixed interest. Once that’s over, the loan has a variable interest rate. This means that the interest rate can change once per year after the fixed-rate portion of the loan, and it can increase or decrease depending on the economy. Because the interest rate can vary, your payments can change, too.
You may also see these types of loans referred to as variable-rate mortgages or floating mortgages. For the best ARM mortgage rates, you will need to research several lenders, compare different types and also ensure your application is appealing to lenders.
When shopping around for ARM loans, you will see that they are often called 5/1, 7/1 or 10/1 ARMs. All this means is that the mortgage will have 5, 7 or 10 years of fixed rates. After that, the loans will switch to an adjustable-rate that can change once per year.
[ Read: What Is an Interest-Only Mortgage? ]
When you borrow money with an ARM loan, the adjustment period between the rate change will be listed in your agreement’s fine print. This will tell you exactly when your interest rate will start fluctuating.
Because ARM mortgage rates fluctuate, they may not be ideal for some people. However, they can be a smart financial choice for certain home buyers or those who pan to refinance, sell or pay off the loan before the rate adjusts.
ARM loans vs. fixed-rate loans
ARM loans and fixed-rate loans have very clear differences, but which is the best choice for homebuyers?
ARM loans will have a fixed-rate period, which is the main similarity ends. ARM loans tend to have lower introductory interest rates when compared with the average fixed-rate mortgages, which is why they can be attractive to some buyers. This means that if you can pay off your loan, sell or refinance before the fixed-rate ends, an ARM loan might save you a ton in interest during the fixed period.
Overall, interest rates are currently low and are likely to remain that way for some time now, so the ARM fixed-period rates aren’t much lower than the rates you’ll get with a fixed-rate loan. Whether they’re low enough to gamble on an ARM will depend on your needs. You’ll have to do the math to decide. However, there is no guarantee that those interest rates will remain low.
What are the different types of ARM loans?
Not all ARM loans work the same way. The main difference between the different types of ARM loans is the length of the fixed-rate period.
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The main types of ARM loans you can take out are as follows:
- 1-year ARM: A 1-year ARM loan means that the interest rate is fixed for just one year. After that year has ended, the annual rate will adjust accordingly. This type of loan is fairly uncommon, as most people will want a fixed-rate period of longer than a single year.
- 5/1 ARM loans: 5/1 ARM loans have five years of a fixed-rate, which is followed by a fluctuating, adjustable rate. This rate typically changes each year and is based on several different factors.
- 7/1 ARM loans: Another common ARM loan type is the 7/1, which has a fixed rate for the first seven years. After that, the adjustable rate can fluctuate once per year.
- 10/1 ARM loans: The longest type of ARM loan that you are likely to see is the 10/1. This loan has a fixed-rate for the first 10 years and then an adjustable-rate afterward. This type of loan is perhaps better suited to those refinancing with 10 years or less left on their mortgage.
- Interest-only ARM: This is an interest-only loan that allows you to only pay interest on your mortgage for a specific number of years. When the interest-only period ends, you will have to make larger payments, as they will include both your interest and principal.
When should you consider an ARM loan?
Different types of ARM loans will suit different situations, so it largely depends on your plans and circumstances. With the right circumstances, ARM loans can be a great way to keep monthly payments on your mortgage low.
Circumstances where an ARM loan is a good idea for you include:
- You plan to own the home for a short period of time: If you know you will relocate within the next few years, an ARM loan could help you save money. You will typically find that 5/1 ARM loans have the lowest interest rates out of the different options. If you are likely to sell your home or refinance in the next five years, this is the most cost-effective option for you.
- You expect to pay off the total balance of the mortgage soon: If you are expecting a large amount of money (from an inheritance, for example) or know you will be able to pay off your mortgage in the next few years, an ARM loan is a great way to get lower monthly payments until you settle the mortgage.
- If you expect interest rates to go down: It’s likely that interest rates will remain low in the near future. Getting an ARM loan ensures you have fixed low-interest rates for a few years. If interest rates remain low when the adjustable period kicks in, the rate might remain low. The problem is that it’s a gamble. You may have to plan to refinance after the fixed-rate period — just to be safe.
[ More: Is Now the Right Time to Get a Mortgage? ]
The main downside with ARM loans is that things can always change. If your circumstances change within the next five years, you may be forced to stick with the adjustable-rate for longer than you expected. If you can’t afford to refinance or move, being stuck on an adjustable-rate may be less than ideal if interest rates start to rise again.
Other considerations related to ARM loans
Aside from the interest rates and options, there are still other things to consider with regards to ARM loans. One of the main is rate caps.
Rate caps
A rate cap is a limit on how much your interest rate can increase. Rate caps can reassure buyers that interest rates on their mortgage won’t shoot up to an unmanageable level after the fixed-rate period ends.
However, if interest rates drop, you won’t necessarily see your monthly payments decrease straight away. Some lenders may wait until the next adjustment period to change the rate — which could be the following year if the lender usually adjusts once per year.
There are a few different types of rate caps to know about.
- Periodic cap: This is a cap on any increases in interest-rate from one adjustment period to the next.
- Lifetime cap: This limits how much the rate can increase throughout the lifetime of the loan. ARM loans must have a lifetime cap in place.
ARM loan eligibility requirements
As will any type of loan, there will be some eligibility requirements to meet before being approved for an ARM loan. To apply for an ARM loan, you will need to submit your financial documents, along with details of the loan amount, the down payment or the current equity if you are refinancing.
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Lenders will also want to see your credit score which will play a vital part in their decision.
The three main things to consider when applying for an ARM loan are:
- Loan amounts limits: ARM loans have limits on how much you can borrow, which is currently up to $ 510,400. This can vary, but as long as you aim for a mortgage under this amount, you could get an ARM loan.
- Down payment: If you are applying for your first mortgage (not a refinance), lenders will expect a 20% down payment if you want to avoid private mortgage insurance. However, the requirements can vary based on the type of loan.
- Credit score: To get the best fixed-rate deal from a lender, a good credit score is a must. The better your credit score, the more likely you are to be approved for a favorable interest rate.
VA and FHA ARM loans
Aside from conventional ARM loans, there are also VA and FHA ARM loans, which are slightly different. Essentially, they work in the same way as regular ARM loans and have the same requirements. The main difference is with the interest rates.
VA and FHA mortgages are two types of mortgage loans that are backed by departments within the U.S. government organizations. VA loans are limited to military service members and their families.
FHA loans, on the other hand, are commonly used by first-time homebuyers because they require lower down payments and have flexible credit requirements. The downside to FHA loans is that they require extra mortgage insurance for a large part of the loan.
[ Read more: The Best Mortgage Lenders ]
A VA or FHA ARM will typically come with lower interest rates than conventional fixed-rate mortgages. Whether a VA or FHA ARM loan is worth it, though, will depend on a number of different factors.
If you know you will only spend a few years in the home, it could be worth opting for an ARM loan to get the lower interest rates. Once the fixed-rate period is over, you can either refinance to another mortgage loan, move or pay off the remainder of your loan.
If you know you will be living in the home for longer than the initial fixed-rate period, you may run into the problem of rising rates. Banking on the idea that interest rates will go down and stay down for the next few years is a bit of a risk. If that gamble ends up wrong, you may be left with a mortgage with higher interest rates than you can pay.
Of course, the rates may also decrease, which would be ideal, but it’s not something you can predict.
Too long, didn’t read?
ARM loans can be a great way to save money on the costs of having a mortgage. You can save a great deal on interest by opting for a 10/1 rather than a 30-year fixed-rate loan or a 15-year mortgage.
There are a few downsides to ARM loans that you need to consider as well, though. After the fixed-rate period, you will be faced with the tough choice of what to do next. Most people will simply refinance, but this is a costly thing to do — especially if you are opting for a short-term 5/1 loan.
The main thing to bear in mind when weighing ARM loans is that your circumstances may change and tons of varying factors could dictate your next move. Your credit score may decrease, your earnings may decrease and interest rates may not follow the current trends. That makes ARM loans a bit of a gamble, so it’s important to think very carefully about what you want to do before you make a move.
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