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What to know about adjustable-rate mortgages (ARMs)

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One of the questions home buyers may want to consider early on in the home-buying process is whether they want a fixed-rate mortgage or an adjustable-rate mortgage (ARM). In recent years with rates on fixed-rate mortgages so low, it’s a question many borrowers probably haven’t spent a lot of time debating.

Couple using a tablet to look at a modern home design.But anytime the economic forecast is for interest rates to rise — as our Chief Economist Scott Anderson expects — it’s probably a good idea to familiarize yourself with the pros and cons of ARMs versus fixed-rate mortgages. Basically, a fixed-rate mortgage provides stable, predictable monthly payments over the life of the loan and ARMs typically have a lower initial payment amount that may increase over the life of the loan.

Rebound ahead?

ARMs represented less than 8% of mortgage applications in the week ending Oct. 31, according to the Mortgage Bankers Association. In the housing boom of 2004-2006, ARMs comprised anywhere from 24-36% of mortgages, according to Freddie Mac statistics.

Although initial interest rates on ARMs tend to be lower compared to fixed-rate mortgages, many homebuyers have opted for fixed-rate loans recently to lock in historic low rates for the long-term.

Some basics that may help

If you are considering buying or refinancing, here are a few things to consider about ARMs:

Understand the fixed-rate time period. ARMs come with various fixed-rate time frames, the most common being a 3/1 ARM, 5/1 ARM, 7/1 ARM, and a 10/1 ARM. This means the rate is fixed for 3, 5, 7 or 10 years, respectively, and adjusts annually after the initial fixed period is over. The adjustment is tied to an index rate which is subject to adjustments up or down over time.

Consider how long you will be in your home. As a general guide, if you will be in a home less than three, five, seven or 10 years, then it may be to your advantage to use a corresponding ARM loan. This way borrowers may have the advantage of a lower interest rate and payment in the short term, and avoid the longer term risk of interest rate fluctuations if they sell the home before the initial fixed-rate period ends.

Are you comfortable with your monthly payment fluctuating year-to-year? After the fixed-rate period, the rate on an adjustable-rate mortgage can fluctuate up or down from year to year. Many homeowners prefer the stability of a fixed-rate mortgage, even knowing they are opting for a higher interest rate, at least initially. But if you are financially able to handle some fluctuation, over the life of the loan you may reduce your interest expense, especially if you do not hold the loan for the full 30 years.

Understand how you will be approved for your loan. Under federal rules governing Qualified Mortgages, which are loans that banks can sell to Freddie Mac and Fannie Mae, lenders determine a borrower’s eligibility for an adjustable-rate mortgage based on the potential interest rate and monthly payment in the 61st month. This means, borrowers seeking a 3/1 ARM or 5/1 ARM are evaluated using not the initial rate but the highest possible adjustable rate in the 61st month. This calculation may reduce the amount a buyer or homeowner can borrow on a 3/1 or 5/1 ARM. This calculation is not needed with 7/1 and 10/1 ARMs, because the 61st month falls into the 7-year or 10-year period when the initial fixed rate is still in effect. In a nutshell, 3/1 or 5/1 ARMs usually carry lower initial fixed rates, but you may not qualify for as large a mortgage as you could with a 7/1 or 10/1 ARM.

Ask your lender a lot of questions. Unlike a fixed-rate mortgage, ARMs come with a lot of variables that borrowers should understand before they apply. Here are five basic questions I encourage borrowers to ask their lender about ARMs:

  • When could the first potential interest rate and payment adjustment occur?
  • How frequently can the interest rate adjust?
  • How high can the interest rate and monthly payment go with each adjustment?
  • If there is a cap, what is the maximum interest rate over the life of the mortgage?
  • If there is a limit, what is the minimum interest rate over the life of the mortgage?

Based on the answers you receive, you can determine if you are comfortable with the risk that comes with an adjustable-rate mortgage. ARMs may not be for everyone, but their lower initial rate and monthly payment certainly makes them worth exploring, particularly if interest rates start to rise. More information on adjustable rate mortgages is available from the Consumer Financial Protection Bureau.

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