There are two ways to buy a home: you can pay for it all in cash or take out a mortgage. For most of us, the path to homeownership requires borrowing money. Fortunately, there are several types of mortgages available. For borrowers who want flexibility in the loan term and in interest rate, there’s a great alternative: adjustable-rate mortgages.
Adjustable-rate mortgages, commonly known as ARMs, provide buyers with the flexibility and affordability they may need in their mortgage financing. In this blog, we will explore the pros and cons of this type of home loan.
What is an ARM?
An adjustable-rate mortgage is a type of home loan designed to let the initial interest rate reset after a certain amount of time, such as three, five or 10 years. Typically, an ARM will offer a lower interest rate at the start of the loan and then the rate will adjust after a period of time to current market conditions. The frequency of the rate adjustment is based on the type of ARM option selected.
For example, a 10/1 ARM has a fixed interest rate for the first 10 years and then the rate adjusts annually after one year. With each annual adjustment, the interest rate could increase or decrease, based on market conditions.
Pros of an ARM
Lenders offer adjustable-rate mortgages to attract potential borrowers, especially first-time homebuyers, who don’t want a fixed-rate loan in a high-rate environment because of the higher monthly payments. ARMs give borrowers a lower introductory rate with lower monthly payments to start, which makes homeownership more affordable.
An ARM is also useful if a buyer expects rates to drop in a few years and wants to have a rate adjustment built into the loan without refinancing. Plus, ARMs benefit those who seek a home loan for an investment property which they intend to sell before the rate adjusts. This lets them take advantage of the initial lower interest rates to save money.
Here are some key reasons you may want an adjustable-rate mortgage:
- If you plan to sell your home before the end of the initial fixed-rate period.
- If you expect rates to drop and want to benefit from an adjustment without refinancing your loan.
- If you need a lower monthly payment than provided by a fixed rate mortgage.
Cons of an ARM
There are downsides to obtaining an adjustable-rate mortgage, depending on your financial situation. The most prominent is that your interest rate could rise higher than you expected when your adjustment occurs, giving you a larger monthly payment than what you had planned for, according to Bankrate.com. Depending on your ARM option, your rate could also continue to adjust each year, putting you at the whim of market conditions and making it harder to budget for your monthly mortgage payments.
Also, if you took out an ARM expecting the rate to drop in a few years and it doesn’t, you will face higher monthly payments which may prompt you to refinance or sell the property. Keep in mind that an ARM is tied to future market rates, so there is an amount of uncertainty that comes with this type of home loan.
How Are ARM Rates Determined?
Interest rates on adjustable-rate mortgages are based on the federal secured overnight financing rate (SOFR) index, which is the interest rates that banks pay to borrow money overnight in exchange for U.S. Treasury securities, according to RocketMortgage.com. ARM rates will increase or decrease whenever there is a change to the index.
How to Apply for an ARM
Many mortgage lenders offer adjustable-rate mortgages as part of their home loan options. Shop around for the ARM options that fit your unique financial situation. Be sure to understand when rate adjustments will occur on your prospective loan and keep track of current interest rates so you will be prepared when your rate adjusts.
If you want more flexibility and affordability in buying a home, an adjustable-rate mortgage is an excellent choice. With interest rates projected to drop in the next year and a housing inventory that remains limited, an ARM may be the most affordable way to buy a home today while keeping your financing options open for tomorrow.
How TCU Can Help
Travis Credit Union offers adjustable-rate mortgages with flexible terms to fit your financial needs. For example, TCU’s 15/15 ARM gives you a lower interest rate than 30-year fixed mortgages, along with 15 years of stable mortgage payments. This can save you thousands of dollars in interest with no balloon payments.
You can explore all the credit union’s home loan options by visiting the TCU Mortgage Hub. If you are already a homeowner, we can help you refinance your existing mortgage to lower your monthly payments or shorten your loan term. To learn more, visit us online, visit a branch or call us at 800-877-8328 during normal business hours.