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Is an Adjustable-Rate Mortgage Right for You?

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Can You Get Around Today's High Rates with an ARM?

When buying a home, mortgage rates are a key factor in how much home you can afford. 

While some of the lowest rates in history were offered during the last few years, things changed drastically. In March of 2022, the Federal Reserve began increasing interest rates to fight inflation and mortgage rates also experienced significant hikes.

Rates peaked at 7.375% in October and have since cooled. And with Federal Reserve’s decision to increase the benchmark rate by only 25 basis points this February, rates could level off or even decline in 2023.

However—there’s no way to predict what’s coming next with any degree of certainty. 

At the close of 2021, experts speculated that mortgage rates would increase in 2022, but nobody predicted them crossing the 7% mark. And with Fed acknowledging that further rate increases might be needed to curb inflation, mortgage rates could go either way in 2023 and beyond.

So, if you missed out on the buying power offered by the low rates of the past, you may now be wondering if there’s a way to maximize your budget and circumvent today’s high mortgage rates. And it’s likely that you’re considering what’s known as an adjustable-rate mortgage (ARM).

Compared to a fixed-rate mortgage, an ARM has both advantages and challenges that must be considered. Let’s take a look at these two options.

Fixed-Rate Mortgages: Likely the most common type of mortgage, you will lock in an interest rate that remains the same throughout the life of the loan, which typically lasts for 15 or 30 years. Your monthly payments will not change, and you will have a predictable monthly payment.

Adjustable-Rate Mortgages (ARMs): This type of mortgage has an interest rate that can change over time. They’re typically offered with a fixed rate for a set number of years, after which the rate adjusts based on an index, quite often on an annual basis. ARMs can offer a lower initial interest rate than fixed-rate mortgages, but can then go up or down, making payments unpredictable.

A Closer Look at the Adjustable Rate Mortgage

Before going with an ARM, it's important to understand the terms and mechanics so that you can make an informed decision. It’s highly recommended that you talk to a real estate agent, lender, or financial professional prior to moving forward. 

For now, let’s look at the fundamentals. ARMs can be broken down into two components:

  • Initial Fixed-Rate Period – At the start of your loan term, this is the time during which the interest rate remains the same. This period can range from 1 to 10 years. 
  • Adjustment Period – After the initial fixed-rate period, the interest rate begins to adjust based on the index plus the margin. Changes can be annual or periodic.

For example, your 3/1 ARM has an initial fixed-rate period of three years before you enter the adjustment period at year four, and your rate adjusts annually. With a 5/6 ARM, your interest rate is fixed for the first five years and then adjusts every six months, starting with year six.

Once the fixed-rate period ends, an ARM doesn’t just switch to the current average mortgage rate. That would be too easy. To calculate the fully indexed rate when it’s time for an ARM to adjust, lenders add two numbers together, the index and the margin.

  • Index – This is the benchmark interest rate that reflects and changes based on general market conditions. The lender decides which index your loan will use (there’s a wide variety) when you apply for the loan, and this choice generally won’t change after closing. 
  • Margin – This is the number of percentage points added to the index to set your interest rate after the initial fixed-rate period ends. Varying between lenders and loan types, this number will be stated in the loan agreement and won’t change after closing. 

Before agreeing to an ARM, you’ll also want to look into the Floor Rate and Cap. 

The Floor Rate limits the lowest your rate can go after the first adjustment. So, if your floor is 3% and fixed-rate mortgage rates were to drop to the 2% range during your adjustment period, the lowest your rate could be is 3% unless you’re able to refinance into a fixed-rate mortgage.

Caps are limitations on the amount that the interest rate can increase or decrease during a single adjustment period or over the life of the loan. Caps help to limit the risk of large increases in the interest rate and provide some stability for borrowers. However, caps don't always apply to your first adjustment which can make that initial change costly. 

Can You Refinance to a Fixed-Rate Mortgage?

ARMs come with a conversion option that allows you to switch to a fixed-rate mortgage at some point. However, it's essential to carefully consider all the factors involved, including interest rate, loan term, closing costs, and other factors, before making a decision. 

You will also need to go through the process of getting qualified for refinancing. Typically you will need to meet requirements such as:

  • Owning the home for at least six months
  • A credit score of 620 for conventional, 580-620 for FHA, 580 for VA
  • Have a debt-to-income (DTI) ratio under 50%
  • Home equity, generally 20% or more–keep an eye on your Initial Fixed Rate Period if you plan to convert before entering the Adjustment Period.

Your lender will also require an appraisal to verify that the home is worth what you are trying to borrow. As for the aforementioned closing costs, your lender may allow you to roll these costs into your loan, which will allow you to keep more money in the bank. Be sure to ask about it.

Final Thoughts

While rock-bottom mortgage rates may be behind us, there are still financing options available to make your home dreams come true. One option is an Adjustable-Rate Mortgage. While it may be a tempting way to get a lower rate today, there’s a lot to consider before you commit. You may be ready to pursue an ARM if:

  • You’ve discussed the pros and cons with a financial professional
  • You’re willing to gamble on lower rates after the fixed-rate period
  • You have the financial flexibility to afford a potentially higher rate
  • You simply plan to sell prior to reaching the adjustment period

You could also look into a mortgage rate buydown and other tools available through your lender. And don’t forget to talk to a reputable and experienced real estate agent. At PorchLight, our team has helped countless clients make smart decisions and achieve their goals. 

If you’d like to learn more about how we can assist you, get in touch today!

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