Learn More About Adjustable Rate Mortgages

You have a variety of options when shopping for a mortgage and your lender can help you decide the most appropriate home loan. As a homebuyer, you undoubtedly want to keep the mortgage payment as low as possible. Thus, the interest rate you receive on the loan is of utmost importance.

As mortgage interest rates drop to record lows, many people see this as the best time to buy or refinance and take advantage of a low, fixed rate. But if you’re looking for the lowest rate possible, consider an adjustable rate mortgage.

Adjustable Rate Mortgages Definition

Adjustable rate mortgages and fixed rate mortgages are both popular mortgage options, but very different. A fixed rate mortgage features an interest rate that remains the same for the duration of the home loan. Regardless of changes or fluctuations in current interest rates, borrowers who agree to a fixed rate mortgage never experience a rate increase. This translates into predictable, unchanging home loan payments, which provides peace of mind.

Adjustable rate mortgages do not operate in this way. The interest rate on adjustable rate mortgages change periodically in response to market changes and economic conditions. Rate adjustments are influenced by an index rate. Common indexes include the Cost of Funds Index (COFI) and the London Interbank Offered Rate (LIBOR). The rate on an adjustable mortgage increases as index rates increase, and decreases as index rates fall. In addition to index fluctuations, adjustable rate mortgages are based on a margin rate, which is a value added to the index rate by mortgage lenders.

How Do Adjustable Rate Mortgages Work?

When shopping for an adjustable rate mortgage, your mortgage lender may present several options, such as a 1/1 ARM or a 5/1 ARM. These numbers indicate the length of your initial fixed rate period and the frequency of each rate adjustment. In the case of a 1/1 ARM, you pay a fixed rate for the first year and the interest rate adjusts every year thereafter. With a 5/1 ARM, you pay a fixed rate for the first five years, with rate adjustments occurring every year thereafter.

Adjustable rate mortgages are well-liked because the interest rate is typically lower than the rate on a fixed rate mortgage. However, there’s no denying the risks. Each rate adjustment can trigger a spike in mortgage payments and create a financial burden. To decrease the risk of payment shock and excessively high rate increases, adjustable rate mortgages do feature interest rate caps.

A periodic adjustment cap limits the amount an interest rate can increase or decrease in any adjustment period, whereas a lifetime cap limits the amount an interest rate can increase over the life of the loan. If your ARM features a 3/6 cap, the interest rate increase or decrease from adjustment period to adjustment period is limited to 3 percent, whereas the interest rate over the life of your loan cannot increase more than 6 percent.

Is an Adjustable Rate Mortgage a Good Choice?

Despite the risks, an adjustable rate mortgage is ideal if you’re able to handle higher mortgage payments in the future, or if you foresee selling your house before your interest rate resets. The allure of a super low interest rate entices many to take out an adjustable rate mortgage. But if you doubt your ability to manage higher loan payments in the future, a fixed rate mortgage might be the wisest alternative. Use an online adjustable rate mortgage calculator to compare possible scenarios and determine whether a fixed rate or an adjustable rate is the best match.