What Is an ARM Loan?
An ARM loan by definition is a type that has a fixed interest rate for a certain period, after which it adjusts to reflect changes in an index rate. ARMs typically have initial interest rates that are lower than those of fixed-rate mortgages, and therefore carry a higher risk of future increases.
As with any type of home mortgage, you’ll need to have sufficient savings and income to qualify for an adjustable home loan. You must also be able to make your monthly payments if the initial fixed rate is replaced with one that’s higher than your current payment.
Most Arm mortgage loans offer either an adjustable rate every year or every six months. When considering which type might be right for you, consider how often you can expect to see fluctuations in your income level or expenses over time.
How Does an ARM Loan Work?
Now that we covered what they are, let’s take a look at how does an ARM loan work.
These loans are variable-rate loans, meaning that the interest rate will change at regular intervals. The interest rate is based on a benchmark index such as the US Treasury 10-year note and adjusts depending on how the index changes over time.
Typically, your initial ARM loan is fixed for five years with an adjustment period of two years after that point. This means that you’ll make monthly payments based on one set interest rate for those five years before your payment amount becomes variable (and therefore higher).
Types of ARM Loans
If you are interested in this type of loan, keep in mind that there are several variants. Before you decide to leave your signature on the dotted line, find out what the three types of adjustable-rate mortgage loans are.
- Hybrid ARM
- Interest-Only ARM
- Payment-option ARM
Hybrid ARM
The hybrid ARM is a fixed-rate mortgage that allows you to make interest-only payments for the first several years. These are not required to be made every month, so you can choose to make them at any time.
If you do decide to pay down your loan balance, it will reduce the amount of money owed on your home. However, even if you don’t want to pay anything extra toward your mortgage each month, this option allows banks flexibility when setting up their loans and offers customers improved interest rates over traditional 30-year mortgages.
Interest-Only ARM
Interest-only loans are a type of adjustable-rate mortgage (ARM). The borrower pays only interest for a period of time, and any principal payments can be deferred until after that period expires. This is beneficial because the borrower doesn’t have to worry about making monthly payments on both interest and principal. However, if they do not plan for future principal payments, there will be more to pay when this payment period ends. Interest-only loans can be risky because they don’t help borrowers build equity over time like traditional fixed-rate mortgages do.
Once the interest-only payment expires, the loan becomes an amortizing loan with regular monthly payments. In addition, lenders may impose prepayment penalties if you repay this type of loan before its maturity date—which means you’ll have to pay extra fees if you want your money back before then.
Payment-Option ARM
A payment-option adjustable-rate mortgage (ARM) is a type of mortgage that allows you to make a choice between different payment options. These payment options include:
- Paying an amount that covers both your principal and interest. This is the only way you can reduce the amount you owe on your mortgage loan with each payment.
- Paying an amount that covers only your interest. Interest-only payments do not pay down your principal, or the amount you borrowed.
- Paying a minimum (or limited) amount that does not even cover the interest. The interest you do not pay will be added to your principal loan balance. This increases the amount of debt you owe.
- A 30 or 40-year fully amortizing payment
- A 15-year fully amortizing payment
These loans are great options for homebuyers who want more flexibility when deciding about their payments or have limited funds available for their down payment or closing costs
Benefits and Drawbacks of an ARM Loan
After we explained what is it and how it works, it’s time to get familiar with some of its benefits and drawbacks. You should consider each and every one of them when taking out the loan so you are sure you will make a well-informed decision. You can always talk to a financial advisor or mortgage counselor to get help if you need it.
Benefits
- Lower interest rate. One of the main benefits of an ARM loan is the low-interest rates that come with it. In fact, one way to think about it is that you’re borrowing at an interest rate below what you would pay on a conventional mortgage.
- Lower initial payment. The other way to think about this benefit is that your monthly payment will be lower than on a conventional loan because there’s no private mortgage insurance (PMI). PMI adds 1% or so to your monthly payments, which adds up over time, especially when combined with higher interest rates.
Drawbacks
- First, they’re more expensive than fixed-rate mortgages. The interest rate is generally higher because it adjusts annually or every few years for the life of the loan.
- Second, ARM loans are riskier than fixed-rate mortgages because your monthly payment could go up when interest rates rise in response to inflation or other economic factors that affect the value of money.
- Third, their payments can increase at any time during your loan term (you don’t get a set number of years with a fixed-rate mortgage).
- Finally, they’re harder to qualify for because you’re taking on more risk as a lender by agreeing to an adjustable-rate mortgage rather than one with a fixed rate over 30 years or 15 years (which are often available only if you have excellent credit).
What’s the Difference Between an ARM and a Fixed-Rate Mortgage?
There is a big difference between an adjustable-rate mortgage vs fixed-rate mortgage. An ARM has an adjustable rate, which means that the interest fees on your loan will change over time. Fixed-rate mortgages are exactly what they sound like: their interest rates remain constant for the life of the loan.
A good way to think about this is by comparing them to a home’s electric bill. When you get your electricity from an electrical utility company, they charge you a certain amount per month based on where you live and how much power you use each month (your “usage”). Your usage can vary depending on the time of year or whether or not it’s summer versus winter (for example). That’s why some people pay more than others at different times during the year.
Some people use more electricity than others because of their lifestyle choices (more lights left on, etc.). If everyone used exactly as much electricity every single month without changing how much they used throughout different seasons or at different times in life then everyone would be paying exactly the same amount for their electricity all year long. It wouldn’t matter when someone got theirs because it would always be priced according to current conditions.
This is also true with mortgages, if everyone paid off their homes entirely every month then no one would have any equity left over after paying off all debts. Due to each billing cycle, there wouldn’t be any differences between payments owed based on when those payments were made during different months/years!
How to Qualify for an ARM Loan
You can qualify for an ARM loan if you have a credit score of at least 680, a down payment of at least 15%, income that meets the lender’s requirements, and the loan-to-value ratio of your home. Additionally, risk tolerance and desire for stability are factors in determining whether or not you qualify.
If you plan on selling your home in the near future or want to avoid having payments increase year over year, then getting a fixed rate is better for you than an adjustable-rate mortgage.
If there’s any uncertainty about your plans (for example: if you’re planning on buying a new home), consider getting an adjustable-rate mortgage so that if rates rise after purchase it won’t impact your budget as much.
When to Consider an ARM Loan?
If you’re looking to buy a home, but think that the interest rate on your mortgage is too high, an adjustable-rate mortgage might be just what you need. An ARM loan can help you afford a home now and pay less over time. Here’s how it works:
- If you expect to stay in your home for less than seven years, then an adjustable-rate mortgage (ARM) may work for you. This is because ARMs typically have lower initial rates and higher payments later on when the rate adjusts to reflect current interest rates. However, if you plan on staying put for longer than seven years then consider getting a fixed-rate loan instead of an ARM because it will save money in the long run.
- Some people prefer ARMs because they are willing to pay more each month and want to save money over the long run by locking in today’s low rates while they can afford them. Others prefer ARMs because they don’t want any surprises to come in renewal time when their monthly payment jumps up unexpectedly like with many other types of loans such as auto or personal lines of credit where some banks won’t notify borrowers about changes until after they’ve taken effect!
Final Thoughts
ARM loans are a great way to get home if you know you’ll be in it for a while, but they have their drawbacks. If you’re considering an ARM loan and want to learn more, talk to your lender or mortgage broker about how they work. They can help ensure that the loan is right for your situation and goals.
If you’re not sure whether an ARM or fixed-rate loan would be best for your situation, ask yourself: Will I stay in this house long enough? Will my income increase over time? Do I have other debts that will make paying off my mortgage difficult? If so, a fixed-rate loan might allow you to save money on interest costs and payments over time.
