An adjustable-rate mortgage (ARM) is a type of home loan that features a fluctuating interest rate. Initially, the interest rate remains fixed for a certain period. After that, the rate on the remaining balance adjusts at regular intervals, which can be yearly or even monthly.
ARMs are sometimes referred to as variable-rate or floating mortgages. The interest rate adjustments are based on a specific benchmark or index, along with an extra margin known as the ARM margin. Until October 2020, the London Interbank Offered Rate (LIBOR) was the standard index for ARMs, but it has since been replaced by the Secured Overnight Financing Rate (SOFR) to enhance long-term liquidity.
In the U.K., homebuyers can also opt for a variable-rate mortgage, commonly known as a tracker mortgage. These loans are linked to a base interest rate set by the Bank of England or the European Central Bank.
How Adjustable-Rate Mortgages Work?
Mortgages help people buy homes or other properties by providing the necessary funds. When you take out a mortgage, you’ll need to pay back the amount you borrowed over a specific period, plus some extra to cover the lender’s costs and the potential loss of value due to inflation by the time you repay the loan.
Typically, you can select the mortgage type that fits your situation best. A fixed-rate mortgage has a consistent interest rate throughout the loan’s duration, so your payments stay the same. On the other hand, an adjustable-rate mortgage (ARM) has a rate that changes with market trends. This means you can take advantage of lower rates, but there’s also a chance your payments could increase if rates go up.
An ARM has two distinct phases: the fixed period and the adjusted period. Let’s break down the differences between them:
- Fixed Period
- Adjusted Period
Another important aspect of ARMs is whether they fall into the category of conforming or nonconforming loans. Conforming loans adhere to the guidelines set by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, and they are bundled and sold on the secondary market to investors. In contrast, nonconforming loans do not meet these standards and are not sold as investment products.
ARMs also have rate caps, which means there are limits on the maximum interest rate a borrower could face. However, it’s essential to remember that your credit score significantly influences the rate you’ll receive. Essentially, the higher your credit score, the lower your interest rate will be.
Types of Adjustable-Rate Mortgage
ARMs typically have three types: Hybrid, interest-only (IO), and payment option. Here’s a brief overview of each one.
Conclusion
When it comes to financing a home or other property, borrowers have a variety of choices. You can opt for a fixed-rate mortgage, which gives you stable payments, or an adjustable-rate mortgage (ARM), which starts with lower interest rates but can change based on market trends after a set time.
There are several types of ARMs, each with its own advantages and disadvantages. These loans tend to work best for specific borrowers, like those planning to sell or refinance before the interest rates adjust. If you’re feeling uncertain about what to choose, it’s a good idea to consult with a financial advisor to explore your options.