Considering an Adjustable Rate Mortgage? Here’s What to Know
Date: September 5, 2018
Interest rates are on the rise, which has made buying a West Chester or Liberty Township home a bit more expensive lately. In order to save money, we’ve seen a number of buyers consider adjustable rate mortgages (ARMs) instead of the more tradition, 30-year fixed rate mortgage.
ARMs can be great. They usually come at lower interest rates and, depending on the size of the mortgage you’re taking out, can save you hundreds of dollars each month.
But ARMs are also a bit more complicated. Here’s what you need to know about ARMs when shopping around for West Chester and Liberty Township homes for sale.
What is an ARM?
An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate and the monthly payment of principal and interest stay the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
To compare two ARMs, or to compare an ARM with a fixed-rate mortgage, you need to consider the maximum amount your monthly payment could increase. Most importantly, you need to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than a fixed-rate mortgage for the same loan amount. In fact, your ARM could be less expensive over a long period than a fixed-rate mortgage—for example, if interest rates remain steady or move lower.
Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It’s a trade-off—you get a lower initial rate with an ARM in exchange for assuming more risk over the long run. Here are some questions you need to consider:
Is my income enough—or likely to rise enough—to cover higher mortgage payments on my new West Chester or Liberty Township home if interest rates go up?
Will I be taking on other sizable debts, like a car loan or school tuition, any time soon?
How long do I plan to own this home? If you plan to sell soon, rising interest rates may not pose the problem they might if you plan to own the house for a long time.
Do I plan to make any additional payments or pay the loan off early?
How ARMs Work
The initial rate and payment amount on an ARM remains in effect for a certain period of time – ranging from just one month to several years. The most common ARMs have rates locked for the first 3, 5, 7 or 10 years. The mortgage is still amortized over a 30-year period, but the rate will begin to vary after that set period of time.
Depending on the type of ARM loan you take out, the interes rate and monthly payment will change every month, quarter, year, three years or five years. The period between rate changes is known as the “adjustment period”. For example, a loan with an adjustment period of one year is called a one-year ARM because the interest rate and payment change once every year.
If you take out an adjustable-rate mortgage, the company that collects your mortgage payments (your servicer) must notify you about the first interest rate adjustment at least seven months before you owe a payment at the adjusted interest rate. The advance notification needs to show:
An estimate of the new interest rate and payment amount
Alternatives available to you
How to contact a HUD-approved housing counselor
For the first interest rate adjustment, as well as for any adjustments that come later that give you a different payment amount, your servicer must also send you another notice, at least 60 days in advance, telling you what your new payment for your West Chester or Liberty Township mortgage will be.
Interest Rate Caps
Having a mortgage where the rate can vary is scary, especially for homebuyers looking at West Chester and Liberty Township homes for sale for the first time. But the good news is ARMs have an interest rate cap. In other words, there’s a limit on the amount your interest rate can increase over the lifetime of the loan.
Most ARMs have a cap somewhere around 5%. So if you lock in at 4% now, the highest your rate could increase is to 9%. After the initial adjustment, your rate usually cannot fluctuate up or down by more than 2% each year.
Let’s use an example. Say you’re buying a West Chester or Liberty Township home for sale for $500,000 and taking out a mortgage for $450,000.
The principle and interest on a 30-year fixed rate mortgage would cost approximately $2,569 per month. This is using an interest rate of 4.75%, which is pretty standard nowadays (and much higher than rates were just a year ago!).
Now, let’s look at your payment with a 5/1 ARM (rate locked for 5 years, adjusting every year thereafter). On a 5/1 ARM, you can probably get a 4% interest rate right now. Now your monthly principle and interest payment is just $2,452 per month – a savings of $117 per month.
At first glance, this seems like a great deal. But remember, your payment could skyrocket at the end of that 5-year period. If your interest rate were to increase by the maximum amount, 5%, your monthly payment could increase to $3,218 per month.
Or it may not increase at all. That’s the tricky thing about ARMs.
So, is an ARM for you?
If you’re going to look into an ARM, decide whether you’re comfortable with the worst-case scenario. If you only plan to be in the home for a few years, an ARM could be a great option. You save on the front end and then can sell before the adjustment period. 10/1 ARMs are also a good option for those looking for a little more long-term security.
And remember, at any point during your fixed-rate period on an ARM, you can always refinance into a traditional 30-year fixed rate mortgage.
Want to learn more? Give us a call today. We’d be happy to put you in touch with one of our partner lenders serving the West Chester and Liberty Township real estate market. It’s always good to interview a few lenders to determine which programs are right for you.