An adjustable-rate mortgage is a type of loan that has an interest rate that is based on an index. In other terms, the interest rate placed on the outstanding loan balance varies throughout the loan period. The initial interest rate is normally fixed for some time, but it becomes reset periodically usually per month or per year.
The index is normally the London Interbank Offered Rate, fed funds rate or one-year Treasury bill. An Adjustable-rate Mortgage (ARM) is also referred to as an adjustable rate loan, floating rate mortgage or variable rate mortgage. Since ARMs are bank statement mortgage loans, applicants need to submit their bank statements to the lender.
Every lender makes a decision on the number of points they will add to an index rate, which is normally several percentage points. Let’s say the London Interbank Offered Rate is 0.5%, the Annual-rate Mortgage can be anywhere from 2.5%-3.5%. Many lenders will maintain the advertised rate for a particular period then reset it at regular intervals. After the reset, the index rate will go up as the London Interbank Offered Rate does.
Pros of ARM
The benefit of ARMs is the fact that the interest rate is lower compared to fixed-rate mortgages. You can purchase a bigger home for less, and this is especially attractive to new homebuyers and those with moderate incomes.
Cons of ARM
The biggest downside of ARMs is the fact that your monthly payments can skyrocket when interest rates go up. Many homeowners are surprised when rates reset, even though the condition is clearly stated in the contract. Given that your income has not increased, then you might no longer be in a position to afford your house, and could easily lose it.
Types of Adjustable-rate Mortgages
ARMs become popular back in 2004 because that was the year when the Federal Reserve started to raise the fed funds rate. The demand for conventional loans reduced while the interest rates went up. Banks came up with ARMs to reduce the monthly payments. Here are some popular types of adjustable-rate mortgages:
1. Interest Only Loans
These loans offer the lowest interest rates. Monthly payments go toward the interest and not on the principle for the starting 3-5 years. After that period, higher monthly payments are made to cater for the principle, or there may be need to make a huge balloon payment.
2. Payment Option ARMs
This bank statement mortgage allows borrowers to decide the amount to pay every month. They begin with ‘teaser’ rates of around 1-2%, which are then reset to higher rates, even after making the first monthly payment. A higher percentage of option ARM borrowers pay only the minimum payment every month. The remainder gets added to the outstanding mortgage loan balance, similar to negative amortization loans.