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Adjustable-rate mortgage (ARM) loans can be an attractive alternative to a fixed-rate mortgage because they offer lower introductory interest rates. But after the initial fixed period, the rate becomes variable, adjusting along with market rates.
Fortunately, ARMs include a few different rate caps, which can limit how much your interest rate can rise. Knowing what the caps are and how they affect your loan is important if you're considering this type of home loan.
How Does Adjustable-Rate Mortgage Interest Work?
Fixed-rate mortgages are the most popular type of mortgage loan, primarily because they keep your interest rate and monthly payment fixed for the duration of the loan repayment period. This offers you predictable monthly payments even in the event that interest rates rise.
However, ARMs can be appealing if you're looking to save some money upfront and plan to move or refinance within a few years. If you hold on to your loan for longer, though, you may face fluctuations in your monthly payment.
ARMs start off with a fixed interest rate for a set period, typically three, five or even 10 years. During this time, your monthly payments will stay the same, and your interest rate will typically be lower than if you had chosen a fixed-rate mortgage instead.
After that initial fixed period, though, your loan's interest rate can change every six to 12 months, depending on the lender and your loan agreement. The lender will adjust your rate based on a benchmark of current market rates, which means it can go up or down depending on the underlying benchmark.
Three Types of ARM Rate Caps
Having a variable interest rate on a mortgage loan can be scary, especially if you can't afford an increase in your monthly payment. But while you're taking on the risk of fluctuating rates, lenders typically have caps in place to prevent your monthly payment from getting out of control too quickly. Here are the three different types of ARM rate caps.
This cap limits how much your interest rate can go up or down the first time it adjusts after your fixed period ends. Common limits include 2% and 5%, meaning that your new interest rate can't be more than 2% or 5% higher or lower than the initial fixed rate.
Also called a subsequent cap, your loan's periodic cap limits how much the interest rate can change in subsequent adjustments after the initial one. It's common for lenders to set a periodic cap of 2%.
This cap limits how much the loan's interest rate can increase or decrease from the initial fixed interest rate over the life of the loan. The most common lifetime cap is 5%, but some lenders may go higher than that.
How to Compare ARM Loans
ARM loans are much more complex than fixed-rate mortgages, so it's important to know what you're looking at when you shop around. Here are a few ways to compare your options:
- Know the different types. There are a few different types of ARMs out there, but the most common is the hybrid ARM, which gives you an initial fixed period and an adjustable period. Lenders typically signify how long the fixed period is and how often your rate will adjust with two numbers. For example, a 5/1 ARM gives you a five-year fixed period and will adjust your rate once a year after that. In contrast, a 7/6 ARM gives you a seven-year fixed period, after which your rate will adjust every six months.
- Watch out for rate caps. As with the type of ARM, lenders will often list their rate caps in a sequence of numbers. For instance, a loan with 2/1/5 caps has a 2% initial cap, a 1% periodic cap and a 5% lifetime cap.
- Consider the initial rate. Even though you're getting a better rate compared to a fixed-rate mortgage, it's still wise to shop around and compare ARM rates from multiple lenders to ensure you're getting the best deal. And remember, even if one lender offers a lower upfront rate, it may have higher caps than its competitors.
- Know the highest potential payment. Review the Truth-in-Lending disclosure or ask your lender to calculate the highest possible payment you may need to make on the loan based on its rate caps. Depending on whether or not you can budget for increasing rates, it may make sense to opt for a fixed-rate mortgage instead.
Take your time to carefully consider all of your home loan options before you settle on one. Also, consider consulting with a mortgage professional to get expert insight for your situation and needs.
Make Sure You're Credit-Ready for a Mortgage Loan
Before you apply for a home loan, it's important to ensure that your credit history is in good shape. Check your credit score and your credit report to determine where you stand and whether you need to make some improvements before applying. While you can technically get approved for a mortgage with a 620 credit score, the higher it is, the better your odds of securing a low rate.