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An adjustable-rate mortgage (ARM) is a unique type of home loan. While a fixed-rate mortgage keeps the same interest rate for the life of the loan, an ARM's interest rate periodically fluctuates. It might be a good option for some homebuyers, but its complexity can be a lot to digest. That's why we put together this list of common adjustable-rate mortgage terms. If you're considering an ARM to buy your next home, here are eight things to keep in mind.
1. Adjustable-Rate Mortgage Periods
ARMs typically begin with a lower interest rate, then adjust at regular intervals in the future.
- Fixed-rate period: The length of time your initial interest rate lasts. During this time, your rate and monthly payments both stay the same. Fixed-rate periods typically last anywhere from three to 10 years.
- Adjustment period: How often your interest rate will reset after the fixed-rate period ends. ARM rates usually adjust annually or every six months.
2. Convertible ARM Loan
A convertible ARM functions like a regular ARM, but borrowers can convert their mortgage to a fixed-rate loan when the introductory period is over. They make the most sense when interest rates are falling. They also don't require closing costs to convert the loan. But if interest rates rise, it could leave you stuck with a higher monthly payment later on. Borrowers are not required to convert their loan and can keep it as an adjustable-rate mortgage if they prefer.
3. Annual Percentage Rate (APR)
The APR is the total cost of borrowing money to finance an ARM (or any installment loan or credit card for that matter). In the case of an ARM, it's a reflection of the interest rate plus other costs. Your APR may take the following into account:
- Mortgage points: Fees paid to a mortgage lender in exchange for a lower interest rate.
- Mortgage insurance: Allows borrowers to buy a home without making a 20% down payment.
- Closing costs: Expenses paid when you finalize your home loan. These can include origination fees, home inspection fees, appraisal fees and more.
Homebuyers can "buy down" a lower interest rate by paying for discount points. This is a one-time fee paid at the time of closing. Each point costs 1% of the loan amount and generally decreases the interest rate by 0.25%. Buydowns apply to all home loans, not just ARMs.
If your mortgage is $325,000, then each discount point will cost $3,250. Assuming an initial interest rate of 5.8% for an adjustable-rate mortgage, you could buy two discount points for $6,500—and reduce your rate by 0.50%. That would bring down your monthly payment by over $100.
5. Rate Caps
ARMs vary from lender to lender, but they all have rate caps. This is the maximum amount that rates can increase within a given adjustment period. The details should be in your loan estimate.
- Initial cap: The maximum amount the interest rate can increase during the first adjustment period. It usually ranges from 2% to 5%.
- Periodic cap: The maximum amount the interest rate can change during all subsequent adjustment periods going forward—2% is standard.
- Lifetime cap: The maximum amount the interest rate can fluctuate during the entire life of the loan, which is typically 5%.
ARMs rely on a benchmark rate to calculate adjustments. This rate is tied to an index such as the Secured Overnight Financing Rate (SOFR), the one-year Treasury bill or the U.S. prime rate. The index used will vary depending on the lender, but you can track these indexes online.
7. ARM Margin
This is the number of percentage points that are added to the index to calculate your new rate during adjustment periods. It's set by the lender and stays the same for the duration of the loan. (The index, on the other hand, will probably fluctuate.) If your index is 2% and your margin is 3%, your interest rate will be 5%.
8. Types of Adjustable-Rate Mortgages
There are many types of adjustable-rate mortgages. When comparing rates, you'll notice a two-digit ratio used to describe ARMs. The first number represents the length of the fixed-rate introductory period; the second is how often the rate will adjust once that period ends. Shorter fixed-rate periods usually have lower initial rates.
- 5/1 ARM: Fixed interest for 5 years, then it adjusts annually.
- 5/6 ARM: Fixed interest for 5 years, then it adjusts every six months.
- 7/1 ARM: Fixed interest for 7 years, then it adjusts annually.
- 7/6 ARM: Fixed interest for 7 years, then it adjusts every six months.
- 10/1 ARM: Fixed interest for 10 years, then it adjusts annually.
- 10/6 ARM: Fixed interest for 10 years, then it adjusts every six months.
The Bottom Line
An adjustable-rate mortgage could be a great way to land a lower-than-average interest rate. It can also be a good option for folks who plan on moving before the introductory period ends—at which point their interest rate will likely go up. That said, some homeowners may prefer the predictability that comes with a fixed-rate mortgage.
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