What is an Adjustable Rate Mortgage?

After the 2008 financial crisis, there were a lot of scapegoats touted by the media as the cause(s) of the meltdown. Among the most frequently named suspects were adjustable-rate mortgages, also known as ARMs. It’s not a stretch of the imagination to say ARMs became almost like a four-letter word in the television and online news coverage of the crisis. Although it’s impossible to deny that a high number of ARMs went into default before and during the crisis, it’s also true that adjustable-rate mortgages can be a valuable tool for savvy borrowers looking to build wealth through buying property. 

What is an Adjustable Rate Mortgage?

Every mortgage has an annual percentage rate or APR, which is the amount of interest the mortgage lender charges the borrower for making the loan. Borrowers pay back the loan principal plus interest, which is how the lender makes money on the loan. For a long time, the APR on home loans was mostly set in stone, which guaranteed profits for the lender and stability for the buyer. However, as homes became more expensive and people began moving more frequently, the need arose for a more flexible financing option. This is where adjustable-rate mortgages came into the picture. 

An adjustable-rate mortgage is a mortgage where the interest rate can change at various points throughout the life of the loan. They differ from traditional fixed mortgages, which get their name from the fact that the interest rate remains the same for the entire loan term. The base APR of an ARM is usually tied to a public benchmark, such as treasury bills or a particular market index. Then the APR for the mortgage is set at a certain percentage above that benchmark. Afterward, the APR can go up (or down, but usually up) based on that benchmark’s performance in the market. 

How Often Does the Interest Rate Adjust on an ARM?

There is no maximum legal number of times the APR on an adjustable-rate mortgage can change. It all depends on the agreement between the lender and the borrower, although the lender’s say usually carries the most weight because it’s the one choosing to lend the money or not.

With that said, the number of times the APR can change during the life of the loan will be specified in the mortgage contract. Some mortgages call for the APR to change multiple times in the same year, whereas others might adjust the APR over longer periods — usually 5 to 7 years. 

This is why you must read everything you sign quite carefully. If your bank (or state) only allows a certain number of rate changes, that’s great. If not, you could be in for a bumpy ride.

Types of Adjustable Rate Mortgages

There are several different types of adjustable rate mortgages available, each with its own specific features and benefits.

Hybrid ARM

A hybrid ARM combines the characteristics of a fixed-rate mortgage and an adjustable-rate mortgage. It typically starts with a fixed interest rate for a certain period, such as 5, 7, or 10 years, and then switches to an adjustable rate for the remaining term of the loan.

Option ARM

Also known as a pick-a-payment mortgage, an option ARM gives borrowers the flexibility to choose from different payment options each month. These options usually include a minimum payment, an interest-only payment, a 30-year amortizing payment, and a 15-year amortizing payment. The interest rate adjusts periodically based on market conditions.

Two-Step ARM

With a two-step ARM, the interest rate remains fixed for an initial period, typically for one or two years. After this initial period, the rate adjusts annually for the remaining term of the loan.

Balloon Mortgage

This type of ARM offers lower monthly payments for a fixed period, usually 5 to 7 years, followed by a larger final payment (balloon payment) at the end of the loan term. The interest rate adjusts annually during the initial fixed period.

The Benefits of an ARM

As discussed in the opening section ARMs got a very bad rap after the 2008 financial crisis. This has led to the widespread misperception that ARMs are debt traps designed by predatory lenders looking to exploit consumers. However, the reality is that there are a number of potential benefits to consumers in taking out ARMs. 

One of the main benefits to consumers is that since the introductory APR is usually lower, they can borrow a lot more money than they could with a traditional fixed-rate mortgage. What this means is that ARMs allow borrowers to buy a lot more house with the same down payment than they could with a fixed-rate mortgage. Depending on the location of the house and how hot the local market is, there is even a chance that the house will appreciate in value enough to cancel out the rate adjustment. 

Additionally, borrowers with ARMs can plan for rate increases because they will be scheduled in the mortgage. That means they may have to refinance the property more often than fixed-rate mortgage holders, but with current rates at historic lows, refinancing is not a difficult proposition. 

In spite of what you may have heard, ARMs can be very easy to understand and manage. The amount of any APR increase is capped in accordance with applicable state lending regulations where the mortgage is made. This is in addition to the fact that both the increase (or formula for the increase) and the number of times the rate will adjust is also specified in the mortgage.  So for example, a 5/5 ARM means the borrower will have a fixed rate for 5 years before the interest rate adjusts, and it will adjust every 5 years after that for the term of the mortgage. 

Who Needs an Adjustable Rate Mortgage?

There are several types of borrowers who would benefit from adjustable rate mortgages.

Borrowers Who Frequently Relocate for Their Employment

Borrowers who move frequently for their jobs but still want to take advantage of the tax benefits that come with homeownership are great candidates for adjustable-rate mortgages. There is no need for them to take out a fixed mortgage at a higher interest rate on a house they know they are going to sell in 2 or 3 years when they get their next job. 

If you’re the sort of person who follows the job every few years, don’t be afraid to grab an ARM. This is a good choice because you keep costs down for a few years before you move on. However, you should prepare to refinance if you finally decide to settle down. Also, if you move on and keep the home as a rental property, you definitely want to refinance while you still can.

Borrowers Who Have Upward Mobility Careers

The same thing holds true for borrowers who are fortunate enough to be in careers where they are experiencing sustained upward mobility. If you work in a booming field or a hot startup and you’re positive your income will be increasing in the coming years, taking advantage of the low interest rates offered by ARMs and continually refinancing before the rate jump will allow you to pay off your home faster.  

Home Flippers

Home flippers also prefer ARMs because the lower APR allows them to buy nicer and larger properties for less money. The logic here is that the larger and nicer the property they buy is, the more money they can flip it for after renovations. Home flippers are not deterred by the prospect of a rate increase because they plan to sell the property long before the increase kicks in. 

Borrowers Who Want to Quickly Settle Their Mortgages

Borrowers who wish to pay their mortgages off as quickly as possible may be well served by using ARMs. The lower interest rate allows them to pay off the loan balance more quickly with the proviso that the borrower keeps refinancing the loan to continually secure the lowest interest rate possible. If you fit any of the above borrower profiles, an ARM may be exactly what you need to get the most bang for your buck!

Benzinga’s Best Mortgage Lenders

Regardless of the reason you may be considering an ARM, it’s always best to shop around. Different lenders have different loans, and if you’re not aware of all your options, you may end up paying more money than you have to. If you’d like to learn more about which mortgage lender may have the best terms for your situation, consult Benzinga’s list of best mortgage lenders below.

Is an Adjustable Rate Mortgage Right for You?

When used properly, ARMs can be a valuable tool in helping consumers build wealth through real estate. On the other hand, buyers who don't fully understand how to navigate the complexities of ARMs could find themselves unable to make their mortgage payments. At the end of the day, the final verdict on whether or not an ARM is right for you boils down to your individual situation and how well you can manage your finances. 

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