How ARM Interest Rates Work
Understanding ARM Interest Rates
If you're considering refinancing your mortgage, you might be faced with a choice between two different types of loans: adjustable-rate mortgages (ARMs) and fixed-rate mortgages. While fixed-rate loans offer predictability and stability, ARMs can be more complicated, as their interest rates can change over time.
Here's what you need to know about how ARM interest rates work:
What Is an ARM?
An ARM is a type of mortgage loan that features an initial fixed interest rate, followed by a variable rate that changes over time based on an established index, such as the prime rate or the London Interbank Offered Rate (LIBOR).
ARMs are usually structured with an initial fixed-rate period of 5, 7, or 10 years, after which the interest rate adjusts annually based on market conditions. For example, if you have a 5/1 ARM, your interest rate will be fixed for the first five years, and then will adjust annually for the remaining 25 years of the loan term.
How Are ARM Rates Determined?
The interest rate on an ARM is determined by adding a margin to the index rate. The margin is a fixed percentage set by the lender based on the borrower's creditworthiness, loan amount, and other factors. The index rate is the rate that the lender uses to determine the interest rate adjustment.
For example, if the lender uses the LIBOR as the index rate and sets the margin at 2%, the interest rate on a 5/1 ARM would be calculated as follows:
- Initial fixed rate (first 5 years): 3.5%
- Index rate (LIBOR): 1.5%
- Margin: 2%
- Adjusted interest rate: 4.5%
If the LIBOR changes over time, the interest rate on the ARM will change as well. If the LIBOR increases to 2.5%, for example, the new interest rate on the ARM would be 5.5%.
What Are the Benefits of an ARM?
There are several benefits of choosing an ARM over a fixed-rate mortgage:
- Lower initial interest rate: Because ARMs feature an initial fixed-rate period, the interest rate on the loan is typically lower than that of a comparable fixed-rate loan, which can save borrowers money on their monthly payments.
- Flexibility: ARMs can be a good option for borrowers who don't plan on staying in their home for the long-term, as they can refinance or sell their home before the interest rate adjusts.
- Interest rate caps: Most ARMs come with interest rate caps, which limit how much the interest rate can increase each year and over the life of the loan.
What Are the Risks of an ARM?
There are also several risks associated with choosing an ARM:
- Interest rate uncertainty: Because the interest rate on an ARM can change over time, borrowers may not know what their monthly mortgage payment will be in the future.
- Payment shock: If the interest rate on an ARM increases significantly, this could result in a higher monthly mortgage payment that the borrower may not be able to afford.
- Refinancing costs: If interest rates rise and the borrower wants to refinance to a fixed-rate loan, this could result in additional closing costs and fees.
Conclusion
Choosing between an ARM and a fixed-rate mortgage is a personal decision that depends on your financial needs and goals. While ARMs can offer lower initial interest rates and flexibility, they also come with greater risk and uncertainty. It's important to carefully consider your options and work with a trusted lender or financial advisor to determine which type of loan is right for you.