Considerations When Choosing An Arm Loan
When deciding whether to choose an adjustable-rate mortgage, take these other factors into account:
- Unexpected changes: You may plan to move or sell your home within a few years, but the unexpected could arise, leaving you unable to sell the home when you want or some life event could keep you from moving as originally planned. This, in turn, could mean that your rates arent what you expected.
- Rising rates: Although your interest rate could go down, it could also rise during the life of your ARM loan. If your interest rate increases, youll have a higher monthly payment. Make sure youre saving money for the possibility of higher rates.
- Prepayment penalty: Some ARMs may have a prepayment penalty. Speak to your lender and make sure you understand the terms of the loan before you move forward .
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What Is A 5/1 Arm
Now that we know a little about the 5/6 ARM and how ARMs operate in general, lets take a look at the widely recognized 5/1 ARM loanan adjustable rate mortgage familiar to many.
As you can see, the 5/1 ARM consists of five initial years at a fixed rate followed by a second period where the rate readjust annually based on the prevailing interest rate + margin. So its very similar to the 5/6 ARM the rate readjustment period is the main difference.
However, as a result of some changes in the greater financial sector, the popular 5/1 ARM is being phased out. Its a process that began over the last year and will continue until the 5/1 ARM is no longer in use by most lenders.* The reason has nothing to do with the adjustment rate period itself but everything to do with financial indices that inform the rates.
How Are Rate Adjustments Made
When you take out an ARM, youre told the rate could change as time goes on. But what would trigger it? The answer is simple: the bank gets to decide based on the current mortgage market, or what they call the index rate. Your ARM paper work will let you know what index the bank will use.
Typically, lenders base rates on the London Interbank Offered Rate . That just means that if the LIBOR market index goes up, your interest rate also goes up. Womp-womp.
On the other hand, your banker will tell you that your rate might decrease if the market changes favorably. But note the key word right there: might.
There are other index rates that banks use to adjust your mortgage too. Some ARMs are indexed to the published Prime Interest Rate of the U.S. Federal Reserve. Others may rely on Fannie Mae and Freddie Mac to determine the rate of increase. Yep, it sounds confusingand they kind of do that on purpose.
Bottom line? No matter what index your lender uses, you can count on one thing: the adjustment will usually be made to the benefit of your lendernot you. The rate may go down, but in todays mortgage market, all trends are pointing up.
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Exploring Arm Margins And Its Relevance To Credit Scores
The ARM margin is an addition to the index rate to determine the fully indexed interest rate that the borrower must pay on the loan. To find the two values, it is mentioned on the loans credit agreement when issued.
Depending on the credit score of the individual who is borrowing the ARM, he or she can expect to receive a lower ARM margin, which would generate a lower interest rate on the loan. It would result in lowered required interest payments hence, it would benefit the borrower.
On the other hand, individuals with a poor credit score would incur a higher ARM margin, which would raise the interest rates on the loan received. It would then lead to higher costs, as they must pay higher interest expenses.
The Adjustable Rate Mortgage Defined
An adjustable rate mortgage , sometimes known as a variable-rate mortgage, is a home loan with an interest rate that adjusts over time to reflect market conditions. Once the initial fixed-period is completed, a lender will apply a new rate based on the index – the new benchmark interest rate – plus a set margin amount, to calculate the new rate.
This new rate can increase or decrease a homeowner’s monthly payments â which may seem a little risky to more conservative borrowers. However, most ARMs have limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan. In addition, when market conditions keep interest rates low, ARM borrowers benefit. Before signing on the dotted line, borrowers should always consider the initial rate, initial rate period, and the adjustment periods when evaluating an ARM.
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Is A 5/1 Arm A Good Idea
Itâs difficult to justify a 5/1 ARM if interest rates are already low, or if the difference between an ARM and a fixed-rate mortgage is low. If the savings are not low enough, then a 5/1 ARM may not be worth the risk of future rate changes.
Instead, borrowers who plan to move out or refinance before five years may be able to benefit from a 5/1 ARM. But keep in mind that there are no guarantees that you will be able to sell the house in five years. The house may lose value as the neighborhood changes or a downturn in the economy might result in a low demand for homes. Of course, itâs possible that the opposite may happen. You can always talk to a real estate agent about the prospects of your local market and a financial advisor about what might be best in your situation.
Similarly, while refinancing can get you out of an ARM, a mortgage refinance means taking out a new mortgage loan to repay the old one. The interest rates at the time of refinance may end up higher than you anticipated, which may make you wish you had taken out a fixed-rate loan at the start. You may also have to pay a few closing costs again, like an origination fee, which might diminish your potential savings if you canât refinance to a lower rate.
If you plan to pay off the mortgage early and want to make use of the 5/1 ARMâs initial low interest, you may benefit if the mortgage doesnât have a prepayment penalty.
What Is An Arm Mortgage
A variable-rate mortgage A mortgage with an adjustable interest rate. The interest rate fluctuates during the life of the loan depending on changes in an index rate, such as the rate on Treasury securities or the Cost of Funds Index. ARMs often have lower starting interest rates than fixed-rate loans. However, because their rates can go up as well as down, they can be more risky for borrowers.
The Federal Housing Finance Agency , which regulates Fannie Mae and Freddie Mac, requires that all loans sold to them under the ARMS program include a maximum rate change limit. This means that if the index used to determine the interest rate rises above the highest level allowed by FHFA, then the loan’s rate must remain there until another index figure drops below this threshold. If the index does not drop below the threshold before the end of the period measured, then the loan will automatically reset itself to a new, lower rate.
Lenders may want to avoid setting ARMs at extremely low rates. If rates decline after the initial set rate is announced, then these mortgages will be worth less than those with higher initial rates. The lender would then be left with additional risk beyond what is assumed when the loan is made.
ARMs are becoming increasingly popular because they allow people to get a home without having to put down a large amount of money. However, because these loans have a variable rate, they may not be appropriate for everyone.
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Advantages And Disadvantages Of Assumable Mortgages
The advantages of acquiring an assumable mortgage in a high-interest rate environment are limited to the amount of existing mortgage balance on the loan or the home equity. For example, if a buyer is purchasing a home for $250,000 and the seller’s assumable mortgage only has a balance of $110,000, the buyer will need to make a down payment of $140,000 to cover the difference. Or the buyer will need a separate mortgage to secure the additional funds.
A disadvantage is when the home’s purchase price exceeds the mortgage balance by a significant amount, requiring the buyer to obtain a new mortgage. Depending on the buyer’s credit profile and current rates, the interest rate may be considerably higher than the assumed loan.
Usually, a buyer will take out a second mortgage on the existing mortgage balance if the sellerâs home equity is high. The buyer may have to take out the second loan with a different lender from the sellerâs lender, which could pose a problem if both lenders do not cooperate with each other. Also, having two loans increases the risk of default, especially when one has a higher interest rate.
If the sellerâs home equity is low, however, the assumable mortgage may be an attractive acquisition for the buyer. If the value of the home is $250,000 and the assumable mortgage balance is $210,000, the buyer need only put up $40,000. If the buyer has this amount in cash, they can pay the seller directly without having to secure another credit line.
Arms Can Affect Your Buying Power
Understand, however, that various programs qualify ARM borrowers differently than they do fixedrate borrowers.
FHA qualifies you at the note rate. Fannie Mae and Freddie Mac qualify 7/1 and 10/1 applicants at the note rate, but they might add two percent to the qualifying rate of a 3/1 applicant.
Still, other lenders use the fullyindexed rate, which is the rate your loan would be if it were adjusting today based on its terms. So if your 3/1 rate would reset to 3.5 if it were adjusting today, that might be your qualifying rate.
It all depends on the loan terms and the lender.
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Should You Refinance Your Arm Mortgage
One of the advantages of an adjustable rate mortgage is that it can reduce your interest payments when interest rates decline. You might get a lower monthly payment without having to complete any paperwork or pay any closing costs. And if interest rates hold steady or decline further, you might continue to save money from future interest rate adjustments.
Another question to consider before you refinance an ARM is the length of your new fixed-rate loan. There are two main factors that affect how much money you will pay in interest over the life of a loan. The first is your interest rate and the size of your monthly interest payment based on this interest rate. The second is how many years you are paying these monthly interest costs. If you refinance from an existing mortgage that has 25 years left until it is paid off to a new 30 year fixed-rate mortgage, you may take longer to pay off the new loan. And pay more money in interest as a result.
What Should I Look For When Shopping For A 5/1 Arm
When youre comparing loan options, there are some special numbers to pay attention to when looking specifically at ARMs. For example, you may see one advertised as a 5/1 ARM with 2/2/5 caps. Lets break down what that means, one number at a time.
- Fixed or teaser rate period: The first number specifies how long the rate stays fixed at the beginning of the term in this case, 5 years.
- Adjustment intervals: The next number tells you how often the rate adjusts once the fixed-rate portion of the loan is over. For this example, the 5/1 ARM adjusts once per year.
- Initial cap: The first cap is a limit on the amount the rate can adjust upward the first time the payment adjusts. In this case, regardless of market conditions, the first adjustment cant be an increase of higher than 2%.
- Caps on subsequent adjustments: In our example above, with each adjustment after the first one, the rate cant go up more than 2%.
- Lifetime cap: The final number is the lifetime limit on increases. Regardless of market conditions, this mortgage interest rate cant go up more than 5% for as long as you have the loan.
Other than the margin in your loan documentation, theres no limiting factor to how much your interest rate could adjust down in any particular year if interest rates have moved lower.
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How Much Can My 7/6 Arm Increase
All adjustable-rate mortgages have lifetime caps, which limit, or cap the maximum amount of interest that can be charged on the loan. These limits are expressed as a percentage increase from the initial, fixed-interest rate. For example, if your 7/6 ARM had a lifetime cap of 4%, and it started at 3%, your interest rate would never go beyond 7% — regardless of what happened in the market.
ARMs also have periodic caps, which restrict the amount that the interest rate can change during any one adjustment period. So, for example, if your 7/6 ARM had a periodic cap of 0.75%, your interest rate could never increase more than 0.75% in any one 6 month period, even if interest rates increased 2% or 3% during that period.
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/1 Arm: Your Guide To 7
A 7/1 ARM can provide you with some stability at the outset of your loan and help you save money on interest.
Edited byChris JenningsUpdated October 11, 2021
Our goal is to give you the tools and confidence you need to improve your finances. Although we receive compensation from our partner lenders, whom we will always identify, all opinions are our own. Credible Operations, Inc. NMLS # 1681276, is referred to here as “Credible.”
When shopping for a mortgage, its common to look for fixed-rate loans. However, adjustable rate mortgages may offer lower interest rates because the rate will adjust after the initial fixed period.
Some ARMs are hybrids, offering a lower fixed rate for a set period of time. The 7/1 ARM is one of these types of mortgages, providing you with a lower fixed rate for the first seven years of the term and making it an attractive option for homebuyers.
Heres what you need to know about 7/1 ARM loans:
What Is A 5/5 Arm And Should I Get One
Editorial Note: The content of this article is based on the authors opinions and recommendations alone. It may not have been previewed, commissioned or otherwise endorsed by any of our network partners.
Choosing an adjustable-rate mortgage means that youre able to enjoy a low, fixed interest rate for the first few years of your loan term, but youll eventually have a variable rate that changes over time. A 5/5 ARM may provide the best features of both worlds, but there are also risks that could make the loan unaffordable in the long run.
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Lower Rates Help You Build Equity Faster
The obvious advantage of an adjustable-rate mortgage is that they carry lower interest rates during the fixed period of the loan. At the time of writing, the lowest rate advertised on a major mortgage site for a 5/1 ARM was about 3.2% compared to a rate of 3.9% for a 30-year fixed loan.
While the difference amounts to a mere 0.70 percentage points, it can make a big difference in your payment. The 30-year fixed mortgage carries a monthly payment of $943 per month, while the ARM carries a payment of about $865.
The smart thing to do might be to take out a 5/1 ARM but make monthly payments as if it were a 30-year fixed mortgage. By the end of the 5-year fixed period, the borrower will have made a much larger dent in their balance than the borrower who uses a 30-year fixed mortgage.
Here’s the math based on a $200,000 mortgage at current mortgage rates.
After five years of equally sized payments, the buyer who used the 5/1 ARM instead of a 30-year mortgage would be more than $7,200 closer to paying off the home in full.
Having more home equity is a powerful buffer should interest rates rise. If, at the end of five years, your rate rises by more than 1 percentage point , your monthly payment will simply match that of the 30-year fixed-rate mortgage. Of course, the $7,200 in additional home equity you built up is yours to keep.