How does an adjustable-rate mortgage (ARM) work?

People are introduced to a wide variety of mortgage types as they go through the process of buying a home. It might seem easy to just choose the same type of mortgage as a family or friend, but it is important to see if a plan is the right fit for your circumstances.

The vast majority of homeowners choose a fixed rate mortgage. These ensure a stable interest rate for the duration of the loan. Their stability and relative affordability make them an attractive option for many people.

Others choose to go with an adjustable-rate mortgage (ARM) so the interest rate shifts over time to match market conditions. This is common among homebuyers who choose FHA loans.

How Does an Adjustable-Rate Mortgage Work?

ARMs start out with an initial rate and payment amount that stays the same for only a limited amount of time, usually from just a couple of months up to several years or more. After, the interest rate and monthly payment will change. The time between rate changes is known as the adjustment period.

For example, a one-year ARM can result in a shift in the interest rate and payment amount on a yearly basis. Interest rates are based on an index like the Libor rate, the yearly Treasury bill, or the federal funds rate, and are also based on the margin, which is an addition amount that the lender adds.

It is up to the homeowner to understand the fine print of an ARM and make sure they will be able to pay the higher interest rates when they do change. The vast majority of ARMs will spell out the highest amount each adjustment can be and the maximum interest rate that can be seen over the life of a loan.

People considering an ARM should also question the lender about how many percentage points the margin is, and should ask about the indexes that ARM rates are based upon.

What Are the Pros and Cons of an ARM?

People often choose an ARM to take advantage of lower payments and interest rates during the early parts of a loan term. The ability for homeowners to save money on their payments can let them buy a larger house or invest the extra capital into another investment vehicle. People who are intending to sell or refinance their home before the initial rate period ends also find it advantageous to opt for an ARM.

However, homeowners who choose an ARM subject themselves to the risk that their payments could suddenly increase rapidly. People who are unable to cope with sharp interest rate upticks could lose their home if they do not have a plan to pay the extra money. It can be difficult to chart out what interest rates and payment amounts will be in the future.

Those interested in an ARM should speak with an experienced mortgage company to go over the pros and cons of ARMs and fixed rate mortgages. For personalized advice, call today to schedule your personal consultation with California Community Mortgage.

Posted in: FHA Loans