There are many varieties of mortgage programs today, but all of them fall into one of two categories – fixed or adjustable. A fixed rate loan is pretty easy to figure out, it’s fixed for the life of the loan and will never change. A fixed rate loan is the more popular of the two, especially for those intending to buy a home and keep it over the long term. Fixed rate loans can be amortized over 10, 15, 20, 25 and 30 years. The longer the loan term, the lower the payment. Longer terms also mean more interest paid overtime.
The second category is the adjustable rate mortgage, or “ARM” for short. But unlike a fixed rate, ARMs offer additional options for the borrower to review. Like fixed rate loans, ARMs can be spread out over different terms but there are many more items to consider. Let’s review them.
As the name implies, an ARM can and will adjust at some point in the future. These adjustment dates are specifically laid out in the note and cannot change without refinancing the entire mortgage. Why would someone choose a loan that will change at some point in the future? Why not just take a fixed rate and not worry about any future changes? Because ARMs come with lower start rates compared to a fixed rate loan which then results in a lower monthly payment.
Features of ARM Mortgage:
An ARM has three primary features- an index, margin and cap. An index is the base number on which to build the new rate. The margin is the amount added to the index to arrive at the new rate to be used when calculating the new payment. To protect consumers from wild rate swings from one adjustment period to the next, rate caps place a limit on how much the rate can change each time. A common index might be the 1-Year Constant Maturity Treasury or CMT. A typical margin is 2.00 or 2.25 and rate caps might be 1.00% at each adjustment period and 5.00% or 6.00% over the life of the loan. Borrowers will be provided with a notice in advance of any rate adjustment, giving the consumes time to adjust to the new payment or refinance into another type of loan.
One of the more common adjustment periods is one year. But there are also ARMs that can adjust every six months. Today however, more ARMs are available in what lenders refer to as “hybrid” loans. A hybrid loan gets its moniker because at the very early part of the mortgage the rate is fixed before turning into a loan that can adjust. Hybrids can be labeled as 3/1, 5/1, 7/1 and 10/1.
These labels identify how long the initial period will last while the “1” in this example tells borrowers the adjustment comes once per year. In all cases, hybrids will still have a slightly lower rate than a fixed rate cousin but slightly higher than a standard 1-year ARM. A hybrid that is fixed for five years but can adjust every six months after that term is labeled as a 5/6 ARM. The allure of a hybrid is the lower, initial rate that is fixed for a predetermined period of time providing stability in the payment and makes financial planning easier.
MORE: Read more about fixed and adjustable rate loans here
Other ARM Types, Interest Only, Etc:
There are also select ARMs that are “interest-only” programs. As the name implies, the borrower can choose to make a minimum payment of interest only but also has the choice of paying the principal and interest amount as well.
Finally, although they are rare in today’s market, some offer “negative amortization “or Neg Am loans. These are types of adjustable rate mortgages where the borrowers have the option of paying less interest than what is charged. When this happens, the loan balance actually grows instead of being paid down. Negative and even interest-only programs are nearly as readily available today as in years past. However, select portfolio lenders may still offer these options in certain cases.
Buyers should know that interest-only and negative amortization ARM loans are not available on any Government backed loan programs like FHA, VA and USDA.
Adjustable rate mortgages can be a bit confusing at first because there are so many moving parts. But they do provide additional options for borrowers to review and definitely have a place in the mortgage market. If someone is not thinking they’ll a property well into the future, a hybrid mortgage or ARM is something to consider. Working with your loan officer and reviewing the differences in monthly payments along with your plans on how long you might keep the property will result in an ideal option for you.
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