An adjustable-rate mortgage (ARM) may be more appropriate as your next home loan than a fixed-rate one.
Adjustable-rate mortgages are thirty years loans where the interest rate can change over time, based on market conditions and pre-set rules governing how by much rates are allowed to adjust.
ARMs introduce mortgage terminology you don’t see with fixed-rate mortgages:
- Initial period: The number of years until the loan’s first adjustment
- Teaser rate: The starting rate that stays in place until the first adjustment
- Index: A variable interest rate used to set the adjusting mortgage rate
- Margin: A constant value used to set the adjusting mortgage rate
- Cap: The boundary for how much a rate can change when it adjusts
Borrowers can choose the number of years in their loan’s initial period and, in general, a lesser number of years correlates with lower initial interest rates.
ARMs offer initial periods of 3, 5, 7, and 10 years. 15-year ARMs are available, too.
When an ARMs initial period ends, the loan adjusts to a new interest rate. The new interest rate is based on the math of (index) + (margin), where index is often equal to LIBOR, and margin is often set to near 2.500%.
However, as protection for consumers, adjustable rate mortgages are limited by how much they can change from year to year. That cap typically sits at two percentage points per year, which prevents your mortgage from jumping to 20% overnight.
With an adjustable-rate mortgage, you’re sharing in the long-term interest rate risk of a mortgage with your lender. And, in exchange for sharing in that risk, your lender will offer you a lower mortgage rate to start.
ARMs can be an excellent way to save money on your mortgage; paying only for the years you need.
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