Adjustable Rate Mortgages and Choosing the Right Home Loan Option for You

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  • Written on May 19, 2022 By Stanley Martin Homes

When buying a new home, it is essential to consider all of the financing options available to you. Most people are familiar with traditional fixed-rate mortgages but not so when it comes to adjustable-rate options. Understanding how adjustable-rate mortgages work is important so you can be sure to choose the best loan option for your financial situation.

What is an Adjustable-Rate Mortgage?

Adjustable-rate mortgages (ARM) are a type of home loan where the interest rate is fixed for an initial period, then adjusted periodically depending on market conditions. This type of loan allows you to take advantage of lower interest rates without locking into one fixed rate throughout the life of the loan.

How does an Adjustable-Rate Mortgage work?

Adjustable-rate mortgages typically start with an initial fixed-rate period, known as the introductory or teaser period. After the introductory period, you will move into the adjustment period, where the interest rates are increased or decreased in pre-determined intervals. The new interest rate is calculated based on the indexand margin. The index is a benchmark interest rate reflecting current market conditions, and the margin is the number of percentage points your mortgage lender adds. Some ARMs let their rates reset semi-annually or quarterly, while others reset yearly.

If you have a fixed index and you don't want to move with it, there are caps and floors that will protect you from a change in your monthly payment. The initial cap is the max amount that the interest rate will change during the first adjustment period. The periodic cap is the max adjustment amount allowed between each period. The lifetime cap is the max adjustment amount for the loan's lifetime.

Here's an example provided by our mortgage partner, First Heritage Mortgage, using a 30-Year 7/1 LIBOR ARM at 3.00% with 2/2/5 caps.

  • The 3% interest rate will be in effect for the first 7 years of the mortgage.
  • After the initial period, the interest rate can be adjusted once a year for the remainder of the mortgage.
  • The interest rate won't change more than 2% in the first adjustment period, won't change more than 2% from the previous rate and won't increase more than 5% from the original rate.

Your adjustable-rate mortgage of $200,000.00 for 30 years has an initial monthly payment of $843.21. Your interest rate remains fixed at 3% for 7 years. After that time, your interest rate is expected to change by 2% every year. Your highest monthly payment, in this scenario, would be $843.21.

While this can be useful in certain situations, there are also other factors that you should consider before deciding whether or not an ARM is right for your situation.

Should you get an Adjustable-Rate Mortgage?

There are several reasons someone would choose an ARM over a traditional fixed-rate mortgage.

You're moving soon after purchasing. An ARM may be a good financing option for you if there is a chance that you'll move or refinance during the fixed-rate period. Whether you're buying a starter home or an investment property that you will soon sell, ARMs allow you to take advantage of the lower monthly payments before the rate changes.

You want lower initial mortgage payments. Since ARMs have lower interest rates during the initial fixed-rate period, borrowers benefit from lower monthly mortgage payments when compared to traditional fixed-rate mortgages.

You qualify for an extended introductory period. First Heritage Mortgage offers an extended initial fixed-rate period of up to 15 years. The extension is especially beneficial for buyers looking for more stability in their payments while taking advantage of the lower interest rate.

At Stanley Martin Homes, we want to help you make an informed decision about your next home purchase and the different financing options available. Through our partnership with First Heritage Mortgage, our SMart Financing means you can buy with confidence.