When shopping around for a mortgage, borrowers often find themselves confused about the types of mortgages that would give them maximum financial value. With all the mortgage makes and structures abound, they’re generally given a choice between adjustable and fixed-rate mortgages. A fixed-rate home loan has a consistent interest rate throughout the duration of the loan at the expense of higher down payments. Its adjustable-rate counterpart, on the other hand, has a more flexible interest rate, which borrowers can take advantage of if the market rates are at the lower end of the spectrum. This guide will show you everything you need to know about Adjustable-Rate Mortgages including how it works and whether it will be a better option for you or not.

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What’s an Adjustable-Rate Mortgage?

The Federal Reserve’s Consumer Handbook defines an Adjustable-Rate Mortgage (ARM) as a home loan where the applied interest on the outstanding balance fluctuates throughout the entirety of the loan. Adjustable-Rate Mortgages usually start with introductory offers of low and fixed interest rates for a pre-determined period of time (varying from 1 month to 10 years) before having a periodic re-adjustment (based on existing market rates) either on a yearly or monthly arrangement. The interest rates would then remain consistent until the next re-adjustment is implemented.

How do They work?

While fixed-rate mortgages are pretty much straightforward, ARMs present a more complex structure. Getting a better understanding of how ARMs work requires exploring the different types available. Here are the most common types you may encounter.

Hybrid ARMs

Hybrid ARMs have a fixed interest rate for the first three (3/1 ARM), five (5/1 ARM), seven (7/1 ARM), or ten years (10/1 ARM) and become adjustable every year (hence, the 1 after the slash). These types of loans are as flexible as they can get from 5/5 ARM loans where mortgages start with a fixed interest rate for the first 5 years and get the interests adjusted every 5 years after that. Similarly, 2/28 or 3/27 ARM loans have a fixed rate for the initial 2 or 3 years respectively, and will have a fluctuating rate on the remainder of the loan. Terms for the latter types of loans may also vary with some lenders adjusting rates every 6 months instead and not on an annual basis.

Interest Only

Otherwise known as I-O, these types of mortgages allow borrowers to pay smaller monthly payments for a period as they do not pay for the principal loan amount for a certain number of years. Monthly payments will subsequently increase as borrowers will start paying the principal and the interest on top of that. Interest rate adjustments will continue to increase regardless of market rates remain the same. Note that interest rates for I-O mortgages throughout the span of the loan as well. A 30-year home loan with a 5-year I-O period, for instance, has borrowers paying interest only for the first 5 years and will start paying the principal as well as the interest over a 25-year period. The rule of thumb here is that the longer the I-O period, the higher the subsequent monthly payments will be.

Payment-Option

A more flexible but much riskier ARM is Payment-Option, it gives borrowers a broad choice of payment options that include:

Traditional Principal and Interest Payment – Set on a pre-arranged loan term (15, 30, or 40 years) and allows borrowers to reduce the amount owed on the mortgage.

Interest-Only Payment – It doesn’t reduce the amount owed on the mortgage but allows borrowers to pay for interest only on a pre-set period

Minimum/Limited Payment – A set minimum that’s below the due interest for the month but greater than the minimum amount of the mortgage. Minimum payment calculations are based on the initial temporary start-up rate. It has other conditions that may lead to balloon payments if left unchecked.

The Bottomline

Opting for an ARM can be smart but if you only intend to keep the loan for a limited time or if you deem rate adjustments manageable. There are no right or wrong choices when it comes to mortgages, in exploring different options, borrowers should still consider their current financial situation and how interest rates will adjust or how their finances will get affected once they start with the mortgage payments.

Choosing mortgages are but the first step in homebuying, albeit, an important one. In the meantime, you can narrow down your homebuying considerations by searching for the perfect home through these available listings.

Disclaimer: Shop Owner Finance/ TL Global is not a lender. We are a real estate training agency. The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.