How does an adjustable-rate mortgage work?

At the start of an adjustable-rate mortgage, you benefit from a fixed rate and monthly payments during what is called the “initial rate period.”  For the rest of the life of the loan, the interest rate will adjust according to an index, usually every year, but it can also adjust every month, quarter, or at other intervals.

A cap on how much the interest rate can increase is put in place.  This limits how much the rate can change during each adjustment, which also limits the amount the monthly payments can increase.

This unpredictable nature is a downside of this type of product, but it does have benefits if you know you will stay in the property for a short period of time.

Consider this:  if your ARM is hard to afford during the initial rate period, it can become unaffordable in the future when the rate adjustments begin.  In the financial world this is known as “payment shock.”

Let’s take for example a 5/1 ARM loan, which seems to be one of the most popular types of adjustable-rate mortgage loans.  This loan has a fixed interest rate for the first five years of the term, defined by the “5.”  After this initial rate period, adjustments will happen every year, defined by the “1.”

The rate and monthly payments during the initial period are usually lower than what they will become for the rest of the life of the loan.  This scenario is perfect if you plan to sell or refinance your home before the five-year period ends.  It would not make sense to keep this type of loan longer than five years if you know your budget cannot afford a significant increase in mortgage payments.

A cap placed on the interest rate helps predict how much you can expect the maximum rate increase to be after periodic adjustments.

What are the pros and cons of an adjustable-rate mortgage loan?

Each loan product is designed to suit a particular borrower situation.  Let’s take a look at some of the advantages and disadvantages of an ARM.

Pros

• You benefit from a lower interest rate and payments during the initial rate period.  Compared with fixed-rate mortgages that have long terms such as 15 or 30 years, ARMs usually have lower monthly payments.
• When interest rates fall, your ARM will adjust its rate as well.  You enjoy the lowered rate without refinancing your home.  On the contrary, if you have a fixed-rate mortgage, you can only benefit from the decrease in rates if you refinance, which involves closing costs and fees.
• ARMs offer flexibility if your life changes in the next few years.  If you move or sell your home and need a temporary-type of loan an ARM is ideal.  You can benefit from a low rate and monthly payments during the introductory period and sell or refinance before the adjustments to your rate begin.
• Various types of caps are available for ARMs.  To limit the amount your rate can increase, caps can be negotiated into your adjustable-rate mortgage contract.  I can discuss with you the risks and benefits of different types of caps.  

Cons

• If an ARM is kept during the life of a loan your monthly payments can significantly increase.  If interest rates rise, so will your monthly payments.  After the initial rate period, the index will determine if your rates will increase and by how much.  
• ARMs are complex lending products compared to fixed-rate loans.  They can be more difficult to understand and monitor.  A benefit of an ARM is paying lower upfront costs when purchasing a home.  However, if you are not prepared or do not understand future adjustments, it can create financial setbacks. 
• Pre-payment penalties can be part of the contract.  If you plan to refinance or sell your home within a specific time period, penalty fees may apply.  As your mortgage specialist I can negotiate these details with the lender to avoid unexpected penalties. 
• You assume most of the risk.  As the borrower, you assume the risk of interest rates rising. This is why lenders reward those who have an ARM loan.  With a fixed-rate mortgage the risk is assumed by the bank, while you are not affected by index rate changes.