Not all mortgage loans are the same. Different mortgage loan products have different minimum down payment requirements. For instance, VA mortgage loans can often be obtained without any money down, while conventional loans typically require at least 3% of the home price. Mortgage loans can also differ in their interest rate structure. Fixed-rate mortgages have consistent (or “fixed”) interest rates throughout the entire course of the loan. The alternative loan to the fixed-rate mortgage is the adjustable-rate mortgage, or ARM. These loans are also called variable rate mortgages, or sometimes floating rate mortgage. In this post, we will briefly go over the basics of ARMs and discuss why you might decide to select one of these mortgages over the alternative.
Basics of ARMs: Fluctuating Rates
The defining characteristic of the adjustable-rate mortgage is its fluctuating interest rate. ARMs will have an introductory interest rate which remains in place for a certain amount of time; after that, the interest rate will changed periodically according to predetermined time schedule. For instance, it’s common to see ARMs which have an introductory rate which lasts for 2 years, and then a new interest rate which changes every year. ARMs can have basically any rate schedule; introductory rate which lasts 3 years and then changes every 6 months, introductory rate which lasts 5 years and then changes every year, and so forth.
How Interest Rates Fluctuate
Once the introductory rate changes, what determines the new rate for the buyer? The answer is that rates of ARMs change according to an index and a margin. The index is usually one of these 3 indices: the maturity yield on 1 year T-Bills, the 11th District “cost of funds,” or the London Interbank Offered Rate. If one of these 3 indices aren’t used, then the lender will use its own index, and that lender-specific index will ensure that the lender receives healthy margins throughout the course of the loan.
Appeal of ARMs: Low Introductory Interest Rates
So what’s the appeal of ARMs? Why would someone want to obtain this type of loan as opposed to the alternative? From a buyer’s perspective, the appeal of the ARM is typically its relatively low introductory interest rate. The introductory rate of ARMs is usually quite low, and this can be attractive to buyers as they may be saddled with other costs in the early stages of homeownership. Of course, this introductory rate will eventually change, and when it changes it nearly always increases. From a lender’s perspective, this is the appeal of the ARM: the higher rates kick in after the buyer is settled. ARMs played a role in the financial crisis of 2008/9. During the crisis, many of the “subprime mortgages” were ARMs. Many unqualified buyers were able to temporarily service their ARM only because of the low introductory interest rate. Once the intro date changed, default would follow. ARMs are better regulated today; there’s more reasonable caps on interest rates and monthly payments. Still, ARMs can be seen as a bit more risky than traditional fixed-rate mortgages because of the uncertainty regarding interest rate fluctuations.
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