Though there are several avenues for securing a mortgage these days, it can be challenging to find the right one. Our commitment to the Orange County community is to facilitate access to different types of loans. Adjustable-Rate Mortgages are among the lending solutions we offer at Money Lender Loans. You can learn more about this type of mortgage from this Article.
What is an Adjustable Rate Mortgage (ARM)?
With an Adjustable-Rate Mortgage, lenders apply varying interest rates on outstanding loan balances throughout the repayment period. Expect your initial interest rate for an ARM to be fixed shortly and reset periodically (after a month or a year). Lenders usually reset the interest rates based on an ARM margin, which acts as a benchmark for the loan. Other terms used to refer to an ARM include a floating rate mortgage or variable-rate mortgage.
A summary of the basic features of an ARM is as follows:
- The initial interest rate refers to the interest rate applied when you first pay an ARM
- An adjustment period is the length of time a loan period, or an interest rate on an ARM remains unchanged
- The index rate is usually tied to changes in the ARM interest rates
- An ARM margin is the percentage points added to the index rate by a lender to determine the interest rate of an ARM
- Interest rate caps are limits on the monthly payment or interest rates applied to the life of a loan or at the end of an adjustment period
- Initial discounts, which work as promotional aids, are offered at the course of a loan payment term to reduce the interest rates
- Negative amortization refers to an increasing mortgage balance, which indicates that the mortgage payments are inadequate to settle all the interest rates on an ARM
- Conversion is the agreement you have with a lender to convert your ARM to a particular Fixed-Rate Mortgage at specified times
- Prepayment terms allow you to pay special fees if you pay off the ARM early
How an Adjustable Rate Mortgage Works
Adjustable-Rate Mortgages can be expressed as two numbers with the first number indicating the length of time for a fixed rate payment. The second number lacks a formula for defining what it indicates. A mortgage calculator can help you compare different ARM types. Highlighted below is a good example of how an ARM works:
The length of time a lender applies a fixed rate to a 3/27 ARM, and a 2/28 ARM is three and two years respectively. With this ARM, the lender will apply a floating rate to the remaining 27 or 28 years. In contrast, a 5/6 ARM will have a five-year fixed rate and be adjustable after every six months. A 5/1 ARM, on the other hand, will have a five-year fixed rate and be adjusted every year.
How Indexes and Margins in ARMs Work
Interest rates for ARMs either increase or decrease at the close of a fixed-rate period depending on an index and a set margin. Most mortgages come tied to one of the three commonly used indexes. The London Interbank Offered Rate, the 11th District cost of funds index and the maturity yield for one-year Treasury bills form part of these indexes. An ARM margin will stay the same even though the index rate changes,
Can You Expect Rate Caps on Adjustable-Rate Mortgages?
Most ARMs feature rate caps to prevent the rates from exceeding a threshold and the payments from changing drastically. Lifetime rate caps limit the highest level an interest rate can reach throughout the life of a loan. Periodic rate caps, on the other hand, set limits on how interest rates can vary from year to year. ARMs may have payment caps (which increase in dollars) to determine the increases on a monthly mortgage payment.
What are Adjustable-Rate Mortgages Intended for?
Adjustable-Rate Mortgages are designed to allow borrowers to pay low initial payments provided they are willing to work with the interest rate changes. It is common for consumers to prefer mortgages with the lowest initial payments based on the advice they get from ARM lenders. Lenders may choose to offer ARMs because they match their funding sources and reduce risks. The mortgage originators may also decide to sell mortgages with fixed rates to reduce any imminent risks.
As a borrower, you may find ARMs less expensive judging by the way they are designed. Most ARMs come with teaser periods, which define a short initial fixed-rate period ranging from one month to one year. With a low teaser rate, your ARM will attract increases in the above-average payments.
Variants of Adjustable-Rate Mortgages
Mortgage originators offer different ARM variants with interest rates that reflect a lender's standard variable rate. The Federal government regulates ARMs through the caps on the interest rates. ARM variants may include cash flow ARMs, option ARMs, and hybrid ARMs as discussed below:
- Cash Flow ARMs
As a mortgage loan with a minimum payment option, a cash flow ARM allows you to decide your monthly payment. You may have the option to settle the outstanding balance at a minimum payment level, 15-year level, or 30-year level. The lender may give you a minimum payment option during the first several years of your loan payment.
- Option ARMs
An option ARM offers you four monthly payment options since it works as a 30-year Adjustable-Rate Mortgage. The payment options include a 30-year fully amortizing payment and a 15-year fully amortizing payment. Others include an interest-only payment and a specified minimum payment. Option ARMs also go by the name “pay-option” or “pick-a-payment” ARMs.
Option ARMs come with a teaser rate as low as one percent translating into low minimum payments in the first year of an ARM. Your lender may underwrite your loan based on your previous mortgage payments. In this case, you may be eligible for a larger loan if your payment history is satisfactory. An option ARM may suit you if you have a growing income and you need flexibility in the mortgage payments.
- Hybrid ARMs
Hybrid ARMs stand out from option and cash flow ARMs since they have both adjustable-rate and fixed-rate characteristics. With a hybrid ARM, you will incur a fixed interest rate for an initial time frame and a floating rate thereafter. For instance, a 3/1 ARM has a 3-year fixed rate and a subsequent one-year adjustment period for the interest rate. Hybrid ARMs allow lenders to facilitate lower note rates since they transfer a small interest-rate risk to the borrower.
A reset date helps determine the date a hybrid ARM will shift to an adjusting payment schedule from a fixed-rate payment schedule. The ARM will float at a margin over a particular index after this reset date. Hybrid ARMs are becoming increasingly popular due to their loan characteristics.
Pricing of Adjustable-Rate Mortgages
When compared to Fixed-Rate Mortgages, ARMs seem to be less expensive. Their long-term fixed rates are higher than the short-term ones since they have an inherent interest rate risk. Loan originators refer this difference to as a yield curve, which is an upward-sloping curve. While ARMs have lower starting interest rates, they have an interest rate risk.
Your responsibility as a borrower is to take the potential interest rate risk when seeking an ARM. With this risk taken, you will not know the future borrowing costs once the rates change. You may expect the rates to rise with the borrowing costs or decrease if the borrowing costs are lower.
Mortgage originators use various computer simulation techniques to analyze and price ARMs. They consider parameters such as interest rate and fair value over the borrowing period of a mortgage. With these factors at hand, lending analysts decide whether issuing out a specific mortgage can be profitable to them. They also determine whether offering the mortgage will pose a tolerable risk to the banking institution.
Prepayment of Adjustable-Rate Mortgages
With an Adjustable-Rate Mortgage, you will repay the principal amount early without facing any fines just like other mortgage types. However, the early payments will only reduce the total cost of your outstanding loan (the paid interest). These payments will not reduce the time frame for paying off the ARM. Your lender will apply a new fully-indexed interest to the remaining principal amount for you to settle it within the given term schedule.
If you chose to refinance your mortgage, your lender will consider this refinancing option as a prepayment. One way of refinancing a mortgage is by taking out a new mortgage and using it to clear the old mortgage balance. Your ARM originator may charge you prepayment penalties if you pay off the loan early or refinance it all together. The penalties can be effective within your first three to five years of taking out the loan.
What are the Advantages of Taking out an Adjustable-Rate Mortgage
When you begin shopping for an ideal home loan, you may be presented with an adjustable rate mortgage as an option. Understanding the advantages of ARMs can help you decide whether this type of mortgage is suitable for purchasing your dream home. The advantages of taking out ARMs are as follows:
- Lower Interest Rates and Early Payments in Your Loan Term
Adjustable-Rate Mortgages usually begin with a pre-determined interest rate for a specified time length. The first interest rate is significantly lower than what you may find in a fixed rate market during this time. With a lower interest rate, an ARM is on a higher level of reliability when compared to fixed rate products.
- Helps You Save and Invest Your Money
A mortgage meant to help you purchase a beautiful house is not intended to leave you financially devastated. With an ARM, you can put your cash in a higher-leading investment if your payment is $100 or less. Your investment portfolio will increase as the return of the higher-leading investment prove lucrative.
- Offers You a Cheaper Way if You Don’t Want to Live in One Place for Long
An Adjustable-Rate Mortgage may suit you if you do not plan on inhabiting one place for a long time to purchase a house. You can consider the ARM as a cheaper way of financing your home. You also get to save the part of the money previously used to own a house.
- Allows You to Use Falling Rates Without the Need to Refinance
Taking advantage of the falling rates of an ARM without refinancing is a wise thing to do. With this strategy, you will not have to pay an entirely new set of closing fees or costs. Instead, you will watch the rates and your monthly payments fall.
Criteria for Choosing Adjustable-Rate Mortgages
Once you understand the various types and features of Adjustable-Rate Mortgages, consider choosing an ideal one. You should evaluate factors such as time, frequency of adjusting the ARM, and interest rates. Here are the questions to ask when seeking an ARM:
How Frequently Do ARMs Adjust?
Most ARMs tend to adjust every year on the special anniversary of the mortgage once the initial fixed-rate period elapses. Your lender may determine the new rate by considering a 45-day index value prior to the anniversary. Other ARMs may adjust every month.
The Length of Time You Plan on Inhabiting the Home
Consider taking a lower-rate ARM if you will be living in the newly-bought house for a few years. A lower-rate ARM boasts of a lower interest rate and payment. You can grow your savings to get a bigger home in the future. The lower-rate ARM will not expose you to higher rate adjustments since you will vacate the home before the period for the adjustable rate begins.
What are the Interest rates of the ARM?
Lower ARM interest rates may allow you to make small payments even if you do not refinance the loan. Consequently, higher ARM rates have lower initial rates allowing you to continue reaping homeownership benefits. Fixed-Rate Mortgages may be better than ARMs when the ARM rates are significantly low.
What is Involved in the Adjustable-Rate Mortgage Process?
Though a mortgage is essential to every homebuyer, finding one can be a bit frustrating. You can get an Adjustable-Rate Mortgage by finding a lender, getting pre-approved, making a home offer, and finalizing the loan. The entire process as follows:
Finding a Lender
Begin your home buying quest by finding a suitable lender instead of looking for a house. Your mortgage originator must be reputable for having competitive pricing and quality service. Look at the closing fees, costs, and interests too.
Getting Pre Approved
Your real estate agent may require you to get pre-approved for the loan before looking at the available homes. With this pre-approval, a lender will review your income, debts, and credit score. ARM lenders use this approach to spot any potential problems associated with your credit.
Making an Offer
Consider making an offer after finding a property you like and can afford. Compare the seller's asking price with the price of similar homes in a particular area. If the seller accepts your offer, draft a purchase contract for formalizing your intention to pursue the deal. You should also submit a copy of the contract to your lender.
Finalizing the Mortgage
ARM mortgage originators use an underwriting process to evaluate you formally. The process helps assess your ability to settle a debt since it requires a thorough check of your assets, debts, income, and credit score. You should quickly respond to any requests for additional details or documents.
Closing on the Property
In this step, you will meet with all the professionals or entities involved in the ARM mortgage transaction. The lender will require you to complete a wire transfer or have a certified check for covering the down payment and closing points. You will receive the Adjustable-Rate Mortgage after going through these steps.
How an Adjustable-Rate Mortgage Compares to a Fixed-Rate Mortgage
In your search for a mortgage, you should consider various loan features. You should also decide whether to choose an Adjustable-Rate or Fixed-Rate Mortgage. Each of these mortgage types has drawbacks and benefits. Most borrowers consider their housing needs, budget, and ability to take risks when choosing one of these two mortgages.
Differences Between a Fixed-Rate and an Adjustable-Rate Mortgage
A Fixed-Rate Mortgage uses the same interest rate throughout the life of a loan. With this kind of mortgage, your interest and monthly principal payments will not change. However, lenders impose higher starting interest rates on Fixed-Rate Mortgages when compared to ARMs. Payments and rates remain constant regardless of the occurrences in the modern economy.
You may find it difficult to be eligible for higher mortgage rates when applying for a Fixed-Rate Mortgage, unlike an ARM. Fixed-Rate Mortgages are not customizable and are virtually similar from a lender to the other one. While ARMs are difficult to understand, you should review the loan conditions before taking them.
Find a Reputable Mortgage Originator Near Me
The process of taking out an Adjustable-Rate Mortgage should be less daunting provided the borrower has met the lender's requirements. At Money Lender Loans, we pride ourselves as a direct lender operating in Orange County, CA. Our clients choose to transact with us since we offer fast approvals and closings requiring minimal paperwork. Contact our company by calling 949-409-4372 to get funded today.
