Adjustable-Rate Mortgage (ARM)

Adjustable-Rate
Mortgage (ARM)

Lower Rates & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid & Less Interest Paid

Benefits

Eligibility

What is an adjustable-rate mortgage (ARM)?

An adjustable-rate mortgage (ARM) is a loan with an initial fixed-rate period and an adjustable-rate period. The interest rate does not change during the fixed period, but once the adjustable-rate period is reached, rates are subject to vary every 6 months.

In reality, ARMs are a hybrid loan product, merging a fixed upfront period with a longer adjustable period. Most of our clients look to refinance or sell their homes before the start of the adjustable period, taking advantage of the lower rate of the ARM and the stability of the fixed-rate period.

The most common ARM types are 5/6, 7/6, and 10/6 ARMs, where the first number indicates the number of years the loan is fixed, and the second number shows the frequency of the adjustment period – in most cases, the frequency is 6 months. In general, the shorter the fixed period, the better the interest rate. ARMs with a 5-year fixed-term or lower can often have stricter qualifying requirements as well.

How are ARM rates calculated?

During the fixed-rate portion of the ARM, your monthly payment will not change. Just as with a fixed-rate loan, your payment will be based on the note rate that you selected at closing.

The interest rate you will pay during the adjustable period is set by the addition of two factors – the index and the margin, which combine to make the fully indexed rate.

Index

The index rate is a benchmark that all ARMs are based on, typically derived from the short-term cost of borrowing between banks. This rate is determined by the market and is not set by your individual lender. Most ARMs nowadays use the Secured Overnight Financing Rate (SOFR) index.

Margin

The margin is a rate set by your individual lender, usually based on the overall risk level a loan presents. This will not change over time and is determined directly by the lender/investor.

Caps

Caps are limitations set during the adjustable period. Each loan will have a set cap on how much the loan can adjust during one adjustment period (semi-annual cap) and over the life of the loan (lifetime/initial cap).

NOTE: Caps (and floors) also exist to protect the lender in the event rates drop to zero to ensure lenders are adequately compensated regardless of the rate environment.

When is the best time for an ARM?

ARMs are market-dependent. When the traditional yield curve is positive, short-term debts such as ARMs will have lower rates than long-term debts such as 30-year fixed loans. This is the normal case because longer maturity means larger risk (and thus a higher interest rate to make the risk worth it for investors). When yield curves flatten, this means there is no difference in rate from an ARM to a fixed-rate option, which means the fixed-rate option is always the right choice.

What are interest rates for ARMs?

The main appeal of an ARM is the lower interest rate compared to the security offered by fixed-rate alternatives. Depending on the financing type, the difference between an ARM and a fixed-rate loan can be anywhere from 1/8% to 1/2% on average. Jumbo loan products often have the most noticeable difference for ARM pricing, since Fannie Mae and Freddie Mac tend to incentivize the purchases of less risky loans for conforming options

Lower Overall Interest Paid

Paying less in interest is the main perk of a 15-year loan, so let’s run the hypothetical numbers to see the difference in interest paid over the course of the loan. Imagine you are taking out a $500,000 loan with a 4.5% fixed interest rate for 15 years. This means a $188,493 payout of interest over the life of the loan. If we look at how a 30-year fixed loan compares, we can see much more in interest is paid.

Using an average of the last 5 years, the interest rate spread on a 15-year fixed-rate loan is about 0.65% lower than the 30-year fixed-rate counterpart. With a 5.125% rate for the 30-year fixed-rate loan, you would end up paying $412,032 in interest. That leaves you paying $223,539 more in total interest with the longer loan term. These savings can be better utilized in other areas of your life, such as retirement savings, education or medical needs, or home improvement goals.

Want to see how much you could save in interest by choosing a 15-year fixed-rate loan? Use the Calculator.

Faster Route to Free and Clear Ownership

Owning a home may feel like it simply provides one of your basic needs. However, homeownership is one of the most popular forms of investing in the U.S. and is often understated as a way to build wealth that can be passed on to future generations. Paying off your loan in the shortest amount of time will be the quickest way to maximize this equity growth and remove one of the most significant debts from your financial profile.

Cons of a 15-Year Fixed-Rate Loan

15-year mortgages come with their fair share of benefits, but there are many reasons why this loan is not the default choice for many homebuyers.

Higher Monthly Payments

Buyers will often opt against a 15-year loan because the shorter loan term puts a heavier strain on their budget. With the loan repayment period cut in half from a traditional 30-year loan, the monthly payment is significantly higher than the 30-year loan. For many, a home purchase is the single biggest purchase they will make in their life, and for some, that cost burden is best spread out over the longest possible period. Many buyers interested in 15-year fixed-rate loans have the funds to buy a home in all cash or have a substantial down payment if needed, so the shorter loan period is a luxury choice for the lowest interest rate.

Lower Purchasing Power

Higher monthly payments limit purchasing power. You qualify for higher purchase prices with longer loan terms, since the monthly payments are a lower percentage of your earnings. For buyers looking to maximize their purchasing power, we often recommend the 30-year term. Extending your loan term from 15 to 30 years can lower your monthly payment by thousands of dollars which can translate to hundreds of thousands of dollars in purchasing power.

Interest Savings Outpaced by Stock Market Returns

Tying up more of your disposable income in your home lessens your overall investment flexibility. While real estate is an excellent investment, one of the main appeals of this investment type is the low cost of capital and high rate of returns. By opting for a shorter loan period, you are willingly paying more each month to pay off your loan quicker. This extra monthly payment could be better used investing in stocks that return a much higher annual rate of return than the < 1% interest rate you save on your loan.

When is the best time to consider a 15-year fixed-rate mortgage?

Taking advantage of the fixed monthly payment and lower total interest paid over the life of the loan is an appealing option to buyers who are not worried about paying the higher monthly payment each month.

When interest rates drop, astute borrowers will be quick to lock in the lowest fixed rate possible. This way, when market volatility hits and rates rise, the 15-year payment structure protects their minimum monthly payment and offers the most savings long-term.

If you are halfway through paying off your 30-year mortgage, you can opt to refinance into a 15-year fixed-rate loan to take advantage of a lower interest rate and still end up paying your loan off in the same amount of time. However, the interest rate improvement must be significant enough (typically at least 0.5% or more) in order to offset the large amount of interest that is paid off in the first 15 years of a 30-year loan.

Mortgage Insurance – What is it and when is it required?

Mortgage insurance is a mandatory addition to more lenient financing options that acts as an added protection for your lender in the event of a default. By requiring this additional payment, lenders allow buyers to purchase homes with far less than the 20% down that was needed in the early days of homebuying. Although mortgage insurance may seem like an additional burden to many buyers, the addition of mortgage insurance to loans has increased home accessibility to millions who cannot afford to save for a 20% down payment to buy a home.

Government loans, such as FHA financing, have mandatory mortgage insurance that is required for the life of the loan and cannot be removed. This is composed of an upfront mortgage insurance premium as well as a monthly mortgage insurance premium. VA loans don’t have mortgage insurance but do include an upfront funding fee that is similar to the FHA upfront mortgage insurance premium.

Mortgage insurance tends to be slightly cheaper for 15-year fixed-rate loans compared to 30-year fixed-rate loans, since the shorter loan term entails less risk of default and quick accumulation of equity.

Private Mortgage Insurance (PMI)

Private mortgage insurance is required for all conventional loans with a down payment of less than 20%. Borrowers can opt to pay this monthly (most popular), in a lump sum at closing, or finance the lump sum into the loan. The cost for PMI varies depending on credit score, down payment, and loan term.

Once a homebuyer accrues 20% equity in their home, they can petition to have this monthly payment removed from their loan, often by ordering an appraisal to confirm the value of their home. Otherwise, mortgage insurance is automatically removed once you accrue 22% equity in your home.

Jumbo loans with less than the standard 20% down will also have mortgage insurance on the loan, although this is typically paid for by the lender and passed on to the buyer in the form of a higher interest rate.

Down Payment Options for a 15-Year Fixed-Rate Mortgage

With a 15-year fixed-rate loan, buyers can still take advantage of the most lenient minimum down payment requirements for each financing type listed below:

Conventional:
3% minimum for low balance loans (loan amounts below the 2022 limit of $647,200)
5% minimum for high balance loans (loan amounts in high-cost counties above $647,200 and below $970,800)
FHA: 3.5% minimum
VA: 0% minimum
Jumbo: 10% minimum – 20% for best price options

Is a 15-year fixed-rate mortgage right for you?

There is no one-size-fits-all for mortgage financing. The best way to determine whether a 15-year fixed-rate mortgage makes the most sense for you is to talk to one of our mortgage experts at Lendexa mortgage. Our experts can walk you through monthly payment scenarios, give you current interest rates, and discuss any other questions or concerns you might have.

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Pros & Cons of Adjustable-Rate Mortgages

Pros

Lower Initial Interest Rates

Because of the risk you take on knowing your rate can change in the future, an ARM is structured so you get a lower interest rate in the first several years of the loan compared to a fixed-rate loan. These initial savings can be reinvested to pay off the loan faster or used to pay for home upgrades and expenses.

Flexibility

Due to the flexibility that a refinance allows, it is not hard to take advantage of the lower fixed-rate period of ARMs and then refinance into another ARM to effectively extend this fixed-rate period.

For borrowers looking to sell in the near horizon, there is no downside to taking advantage of an ARM’s lower monthly payment if it is available, given the loan will be paid off far before the adjustable period begins

Possibility of Lower Adjustable Rates

In the unlikely event that interest rates fall, you could theoretically be left with a lower monthly payment during the adjustable period if the index your loan is based upon goes to 0%. While this is a beneficial scenario, when rates fall you will often see refinance opportunities for fixed-rate loan options that may be even lower.

Cons

Subject to Market Volatility During the Adjustable Period

Since your loan will be adjustable, your monthly payment could change without any adequate preparation. Since you cannot predict the market years down the line from your home purchase, by sticking with an ARM long term you are potentially leaving your monthly payment up to chance with the adjustable-rate period.

More Complex and Harder for Financial Planning

Taking full advantage of an ARM requires financial planning to see when a refinance opportunity makes the most sense and potentially forecasting if interest rates will remain at a level you are comfortable refinancing into in the future. If this seems to be too much risk and not enough reward, the traditional fixed-rate loan may be the best option for you.

High Risk Level

If you are considering an ARM you should think to yourself, “will I be able to afford this loan if the monthly payment increases?” If you have hesitancy about this, then you may be more comfortable with a fixed-rate loan and the long-term financial security it assures.

Who should consider an ARM loan?

Short-Term Homeowners

For clients looking to sell a home before the fixed-rate period of an ARM ends, taking the lowest possible rate during that period makes the most sense financially. Likewise, these owners would be wise to avoid paying discount points to lower their interest rate since this upfront cost of points will not be recouped if the home is sold in the short term.

Borrowers Looking To Refinance Soon

ARMs are best utilized with a future refinance, either from an ARM to another ARM to extend the fixed-rate period, or from an ARM to a fixed-rate to achieve long-term stability (especially when rates are expected to trend upwards).

Who should consider a fixed-rate loan instead of an ARM?

Risk-Averse Borrowers

Future interest rates are unpredictable, so an ARM is not desirable for those who worry about what the future market may entail. Taking out an ARM requires a comfort level with the risk that monthly payments could increase in the future.

Long-Term Homeowners

For borrowers who are not looking to sell or refinance, locking in a rate that you are comfortable with for the life of the loan is the most appealing option. If this is going to be your forever home and you want this purchase to be a one-and-done, the fixed-rate loan is the best option for you if you are comfortable with the monthly payment.

Buyers Who Want Simplicity

The 30-year fixed-rate mortgage is the ultimate “set it and forget it” loan, which is why a vast majority of our clients choose this option. For many, the mortgage space is already crowded with too many confusing terminologies and products, and going with the secure option may be the best route to owning a home and paying a mortgage that you know will not change for the life of the loan.

Is an adjustable-rate mortgage (ARM) right for you?

The best way to determine whether an ARM makes the most sense for you is to talk to one of our mortgage experts at JVM Lending. Our experts can walk you through monthly payment scenarios, give you current interest rates, and discuss any other questions or concerns you might have.