What is an ARM?
Traditional fixed rate mortgages have an interest rate that remains in place throughout the life of the loan, but the interest rate in an adjustable rate mortgage (ARM) can change at certain predetermined points.
Several types of ARMs are available, labeled by their initial interest rate period. For example, a 10/1 ARM has a fixed interest rate for 10 years, and then the rate adjusts once each year after that. A 7/1 ARM is fixed for the first seven years, etc.
When it’s time to adjust, the lender sets the new rate by looking at an index that most financial institutions use as a benchmark for loan rates. The lender takes that index and adds a margin, which stays the same during the life of the mortgage. For example, if the index is 3 percent and the margin is 2 percent, the rate will adjust to 5 percent. At the next adjustment, if the index is 2.5 percent, the margin is still 2 percent, so the loan rate will be set at 4.5 percent.
Since future interest rates are hard to predict, prospective borrowers may be concerned about upward adjustments due to inflation or other economic conditions. In order to help protect borrowers against extremely high interest rates, most ARMs include an interest rate cap limiting how high the rate can be or how much the interest rate can change from one year to the next. This provides some certainty around what a borrower can expect to pay.
One of the main advantages of an ARM is that the initial interest rate is usually lower than that of a fixed rate mortgage, making it easier for the borrower to qualify for the loan and to afford the monthly payments. A lower rate can help a borrower purchase a more expensive home, or enjoy lower monthly payments, than if they had a fixed-rate mortgage.
Another advantage is that, if interest rates fall, the borrower can enjoy lower interest rates and lower payments without the need to refinance the mortgage.
Before deciding on the type of mortgage that's best for you, ask yourself these questions:
- How large a mortgage payment can you afford today?
- Could you still afford an ARM if interest rates rise?
- How long do you intend to live on the property?
- In what direction are interest rates heading, and do you anticipate that trend to continue?
The best advice for anyone trying to decide between mortgage options is to consult a professional with a good track record. Ask for referrals from friends and family and check out online reviews. Then, enjoy your home, knowing you did your best to finance it responsibly.
To find out more about Nevada State Bank’s mortgage loans1, or for specific down payment information, contact a mortgage loan officer.
1. Subject to credit approval. Terms and conditions apply. See a banker for details. NMLS #467014