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Adjustable-Rate Mortgages: How They Work (+Pros and Cons)

May 20, 2022 by Space Coast Credit Union



As mortgage rates continue to rise with hopes of cooling down the housing market, more and more homebuyers have been turning to adjustable-rate mortgages (ARMs) to finance their homes. The current average rate for a 30-year fixed mortgage is over 5%, but for our 5/1 ARM22, its introductory rate is under 3%, which offers significant savings along with other benefits. Not sure if an ARM is right for you? This article will demystify an adjustable-rate mortgage and cover its pros and cons to help you decide.    
 

What is an adjustable-rate mortgage?

Simply put, an adjustable-rate mortgage is a type of home loan where the interest rate can go up or down after set intervals. In most cases, an ARM starts with a lower interest rate than a conventional mortgage for a certain amount of time—in other words, a “teaser” or “introductory” rate, and then the rate changes periodically based on the terms of the loan.
 

How does an adjustable-rate mortgage work?

Let’s look at the types of adjustable-rate mortgages—hybrid, interest-only, and payment-only:
 
  • Hybrid: These are the most traditional type, with a fixed-rate period and then an interest adjustment on a pre-set schedule. You might see lenders offer 3/1, 5/1, 7/1, and 10/1 ARMs. 
    • Example: A 5/1 ARM is a popular choice where the 5 indicates a 5-year period with a fixed interest rate, and the 1 indicates that the rate can thereafter increase or decrease annually. 
  • Interest-only: An interest-only ARM means you’d only pay interest for a certain period, followed by principal and interest payments. Borrowers like that they can start with a low monthly payment, but by not paying on the principal balance, they won’t earn equity in their home.
  • Payment-only: A payment-only ARM essentially allows you to decide your loan terms and payment schedule. With this type of ARM, if you choose to make interest-only payments for too long, you may end up paying higher-than-you’d-like monthly payments.
An ARM is made up of two parts: an index rate, which can change, and percentage points (the margin), which doesn’t change. If you’d like to learn more about what determines your ARM’s interest rate, be sure to ask your lender to provide more details about which of the three indexes they follow.
 

Adjustable-rate Mortgage Pros and Cons

While yes, you’re taking on a risk with an adjustable-rate mortgage, it offers some rewarding benefits in the initial years. But, it’s essential to keep in mind the cons since you’re “gambling the interest rate dice” in a sense down the road. 
 

Pros of Adjustable-Rate Mortgages

ARMs offer some appealing pros worth weighing into your decision making when financing your home: 
 
  • Lower payments and interest initially: Many homebuyers like that an ARM affords them the opportunity to purchase a more expensive house while typically enjoying lower monthly payments. Initially, this could help them save more money each month and give them more time to advance their income to take on higher monthly payments if, down the road, they decide to stay or upgrade to a bigger home. 
  • Caps: ARMs do have safeguards in place called caps that limit how much the interest rate can change. 
    • For example, you may see (2/2/5) after a 5/1 ARM. Let’s break down the (2/2/5):
      • Initial adjustment cap: The first number, 2 in this case, indicates your interest rate can’t go higher (or lower) than 2 percentage points of your initial rate.
      • Subsequent adjustment cap: The second number, 2 in this case, indicates your interest rate can’t go higher (or lower) than 2 percentage points for subsequent intervals.
      • Lifetime adjustment cap: The last number, 5 in this scenario, indicates your lifetime cap, which means your interest rate can’t go higher (or lower) than 5 percentage points of your initial rate for the life of the loan. 
    • Note, some ARMs have a payment cap for the monthly payment in dollars, but this could lead to negative amortization, which is when you’re not putting enough money towards the interest, causing your loan balance to grow. 
  • Ability to refinance your home later: If your introductory rate period is over, and you decide you don’t want to sell your home, you can also convert your adjustable-rate mortgage to a conventional loan. Be sure to check with the lender first about the terms and conditions if you’re interested in refinancing after the fixed-rate period is over.
 

Cons of Adjustable-Rate Mortgages

Like with any home loan, ARMs carry some cons that are worth considering, so be sure to get the finer details from your lender: 
 
  • Unpredictable interest rates: As you’re probably aware, mortgage rates change regularly. After your introductory rate period is over, you may be stuck with a higher interest rate and, therefore, higher monthly payments, than your budget can handle. 
  • Possibility of pre-payment penalty or balloon payment: Some lenders will charge fees if you pay more than requested during the allotted intervals. (Psst, SCCU doesn’t have pre-payment penalties with an ARM, so you can put more money towards your principal balance during the fixed-rate period.) And with some ARMs upon reaching maturity, you’ll have to make a balloon payment, which is a large payment that sometimes is unaffordable.
Note: ARMs aren’t compatible with SCCU’s VA, FHA, or Hero loans. 

Keep in mind that your rate could also decrease for adjustment periods. By law, your lender must give you notice of your initial rate change at least 210 days but no more than 240 days in advance. For subsequent intervals, they must give you 60-120 days’ notice before the change.  
 

Fixed-Rate vs. Adjustable-Rate Mortgage

With a fixed-rate mortgage, your interest rate and monthly payment would remain the same for the entire life of the loan (minus property taxes and homeowners insurance), offering long-term stability for your monthly budgeting. But, you may have a harder time getting a home that costs more or end up with a high interest rate. See all of our home loan options here.
 
  • Who are ARMs ideal for? They’re suitable for homebuyers who are looking for lower monthly payments initially and plan to move out not long after the introductory rate period ends, or for those who plan to refinance later.  
  • Who are fixed-rate mortgages ideal for? They’re ideal for homebuyers who plan to stay in their home for a longer period of time. 

5-year adjustable-rate mortgage example: Using our adjustable-rate mortgage calculator, let’s take a look at what a monthly payment would be for a 5/1 ARM (2/2/5):
 
  • Home price: $350,000 
  • Down payment: 5% of the home's price
  • Loan term: 30 years
  • Beginning interest rate: 2.875%
  • Rate cap (life rate cap): 7.875%
  • Maximum amount the rate will increase at the first interval: 2%
  • Maximum amount the rate will increase at each subsequent interval: 2%
  • Number of months before the first rate increase: 60 (5 years)
  • Number of months between subsequent rate increases: 12 (1 year)
Total initial monthly payment (for 5 years): $1,379.52

Conventional fixed-rate mortgage example: Using our fixed-rate mortgage calculator, let’s take a look at what a monthly payment would be for a 30-year term:
 
  • Home price: $350,000 
  • Down payment: 5% of the home's price
  • Loan term: 30 years
  • Interest rate: 5.25%
Total monthly payment: $1,836.08

According to the above scenario calculations, you’d be saving over $27,000 with an adjustable-rate mortgage vs. a conventional-rate mortgage in the first five years. 
 

Qualifications for an Adjustable-Rate Mortgage

The biggest qualifiers that lenders take into consideration are your credit scores, debt-to-income (DTI) ratio, income information, and down payment amount. At SCCU, we request a credit score of 620 or higher, a 5% down payment, and a DTI ratio below 45%. 

Our DTI ratio worksheet in our Home Buying Center can help you calculate yours. If you’d like to build or improve your credit score, this article can help.

For your ARM application, you’ll need the following information on hand:
 
  • Employment history
  • Addresses from the last two years
  • Income information 
  • The property’s address
  • Bank information
  • Debt information
SCCU makes it easy to apply online, and you can check it regularly whenever you’d like.
 

So why choose SCCU for an adjustable-rate mortgage?

As a credit union, our members’ interests come first. We’re the third-largest credit union in Florida, with over 500,000 members and 60+ branches. Anyone who lives or works in these counties can become a member. We offer adjustable-rate mortgages with up to 95% financing16, terms up to 30 years, and the ability to convert to a fixed-rate loan. Better yet, we also offer fast pre-approval decisions and member service for the life of the loan. If you’d like to learn more about if an ARM is right for you, reach out to us today, and a Team Member will be happy to help.
 
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