What is an Adjustable Rate Mortgage?
An adjustable rate mortgage, or ARM, is a loan with an interest rate that changes periodically, usually in relation to an index, and payments may go up or down.
How an Adjustable Rate Mortgage Can Save You Money
In the history of mortgage lending in America, the average life of a loan is approximately 6 years. Therefore, a question that all borrowers should ask themselves is why do I need a mortgage for 30 years if there is a high likelihood I will sell my home or refinance my mortgage within 6 years? If you don’t have a good answer to this question, then an ARM might be right for you.
Let’s look at a hypothetical scenario on a $300,000 loan to understand why:
- All factors in the two scenarios are the same except the product/rate
- 30 year fixed mortgage interest rate = 4.00%
- 7/1 ARM interest rate = 3.50%*
- You stay in the loan for 7 years, which is longer than the historical average
Under this scenario, if you were to finance your home with a 30 year fixed rate loan, you would pay $41,821.59 in principal and $78,487.07 in interest during that 7 year time frame.
In contrast, if you were to use a 7/1 ARM, you’d pay $44,866.08 in principal and only $68,293.18 in interest in that same 7 year time frame.
This means that by going with a 7/1 ARM, you’d contribute $3,044.49 more to principal and you would save $10,193.89 in interest payments!
If you choose to stay in the same loan for longer than 7 years, your rate and monthly payment can go up or down, but the upward adjustments are limited by a cap so you rate will never exceed a certain interest rate.”
Moreover, if your situation changes and you want to stay in the property for longer than you initially thought, you can always refinance into another ARM or a fixed rate loan at that time.
If interest rates go down, your interest rate could go down. However, not all ARMs adjust down. Some ARMs have “floors” which prevent the rate from dropping below the stated floor amount and often this floor is equal to the margin.
Why Do Adjustable Rate Mortgages Have Lower Rates?
The reason adjustable rate mortgages come with lower rates is that the lender does not have to factor in the risk that this loan will potentially be in existence for 30 years at the same interest rate. This is because ARMs come with a fixed rate for an initial period (typically ranging from 5–10 years) and then they adjust to market rates. Because of the adjustable rate feature, lenders bear less risk that a loan they originate today will be below the market rates in the future, so in exchange for that feature, you the consumer, get a lower interest rate.