A Comprehensive Guide to Adjustable-Rate Mortgages

For almost every homebuyer, whether they’re a first-time buyer or someone upgrading to a larger home, a mortgage is a necessity. You have choices when you apply for a mortgage, which is why we’ve created this adjustable-rate mortgage guide to help you understand your options.
Here at Addition Financial, we work with our members every step of the way as they search for houses and navigate the mortgage process. The information we’ve included here will help you understand how adjustable-rate mortgages work, what to expect if you get one, and the advantages and disadvantages of choosing an ARM loan instead of a fixed-rate mortgage.

How does an adjustable-rate mortgage work?

The most important thing to know about an adjustable-rate mortgage is in its name: the rate is adjustable. That differentiates it from a fixed-rate mortgage, where the rate is locked at the beginning of the mortgage loan term and stays the same until the mortgage is either paid off or refinanced.
Most adjustable-rate mortgages come with an initial interest rate that is usually lower than the rate you would get with a fixed-rate loan. The initial rate is locked in for a specified period that can range from six months to 10 years. The most common term for an initial rate is five years. The terms are expressed with two numbers, so a five year initial rate followed by an annual adjustment period would be a 5/1 ARM.

When the initial period ends, the interest rate may then be adjusted. The largest change usually occurs at the end of the initial period and is made to bring the rate in line with the market. Rates for adjustable-rate mortgages are determined by taking an index rate such as the prime rate or the Monthly Treasury Average (MTA) index and adding a margin to it.

Most ARMs have caps on rate increases, with some broken down into three categories, as follows:

• The initial cap sets a limit on how much your rate can be increased when the initial period ends and is typically separate from other caps.
• The periodic cap limits how much your interest rate can be increased in any one adjustment period.
• The lifetime cap limits how much your rate can increase over the lifetime of your loan and usually excludes the initial increase.

Understanding the basics of how ARMs work can help you decide whether an adjustable-rate mortgage is right for you.

What factors affect an adjustable-rate mortgage?

Adjustable-rate mortgages are impacted by a variety of factors. During the underwriting process, your lender will take your adjustable-rate mortgage qualifications, including your personal credit into consideration. As a rule you’ll need a FICO score of at least 620 (580 for FHA and VA mortgages) and a debt-to-income ratio of 50% or lower. Your down payment and your overall financial situation will also play a role in determining the initial interest rate.

As we noted above, the other factors are the index chosen to determine your adjustments and the margin your lender adds to the index. These things will be disclosed in your loan agreement.

What will my ARM interest rate change to?

It’s impossible to predict how your interest rate will change over the term of your ARM but it will almost certainly fluctuate after the initial rate period. 

If you want an idea of the worst-case scenario, you can use the caps in your proposed mortgage agreement to do so. For example, you would take your initial rate and add the initial cap amount. You could then add your lifetime cap to that to see the highest possible interest rate.

We suggest looking at the highest possible rate (and monthly payment) before getting an ARM. If you can’t afford that payment, then you may want to opt for a fixed-rate mortgage instead.

What are the advantages and disadvantages of an ARM?

Before you commit to an adjustable-rate mortgage, we suggest reviewing these advantages and disadvantages of ARMs to decide whether an ARM is right for you.

Advantages of ARMs

• Low initial rate may make the initial phase of an ARM more affordable than a fixed-rate mortgage.
• Lower monthly payments in the initial phase can make a mortgage easier to afford.
• An ARM can make it easy to save for a larger house if you don’t intend to stay in your home more than a few years, or to make extra payments toward your principal.
• There’s a chance (albeit a small one) that your rate could go down if the market improves.
  
  

Disadvantages of ARMs

• The low initial rate may turn into a much higher rate (and a much higher monthly payment) after the introductory rate goes away.
• Uncertainty about interest rates and payments can make it difficult to budget.
• It may not be possible to sell or refinance at the right time to avoid potential rate increases.
• The rules for ARMs are complex and may be difficult to understand.

Who should avoid an ARM?

Adjustable-rate mortgages make sense for some people, but not for everybody. You should avoid an ARM if any of these things apply to you:

• You have unpredictable income or are worried you might lose income.
• You barely qualified for a mortgage and may not be able to qualify for refinancing.
• You plan to stay in your home in the long term, that is, past the initial fixed-rate period of your ARM.
• You don’t deal well with financial stress and uncertainty.

If you find yourself nodding in agreement reading this list, then you are probably better off with a fixed-rate mortgage to get the predictability and stability you want.

When does it make sense to get an ARM?

There are some situations where getting an ARM makes a lot of sense and can help you financially:

• You’re buying a starter home and know you’ll be moving before the initial period ends.
• You’re buying a home with the intention of renovating and reselling it quickly.
• Your finances are solid and you have plenty of savings to weather a mortgage rate increase if you’re not able to sell or refinance before the initial period ends.
• It’s most advantageous to get an ARM if it allows you to save money on monthly payments and you’re sure you’ll be able to move or refinance before the initial fixed-rate period ends. Some people who flip houses choose an interest-only ARM, which allows them to pay only interest while they renovate.

What are the steps to get an ARM?

The steps in the ARM application process are the same as the steps to get a fixed-rate mortgage. We’ve included a few tips to help you avoid some of the pitfalls of ARMs:

1. Review your credit and finances. Before you apply, ask for copies of your credit reports from the three main credit bureaus and advise them to correct any mistakes. You may also want to calculate your debt-to-income ratio, which you can do by totaling your monthly debt payments and dividing the total by your gross monthly income.
2. Research lenders. It’s always a good idea to shop around and see what lenders have to offer (and read reviews) before you apply.
3. Gather documents. When you apply for an ARM, you’ll need proof of income and employment, copies of your tax returns, bank statements and other documents as specified by the lender.
4. Complete the application. We suggest applying with several lenders, so you can compare rates and terms. 
5. Review your Loan Estimates. Every lender is required to send you a Loan Estimate within three business days of receiving your application. Make sure to review it carefully, but keep in mind that this is only an estimate and may change during the underwriting process.
6. Go through the underwriting process. It can take anywhere from a few days to a few weeks to underwrite your mortgage. Make sure to respond quickly to any questions to avoid delays.
7. Schedule your closing. In most cases, your closing will take place between 30 and 60 days after you receive your approval.
8. Review the Closing Disclosure. Lenders are legally required to send you a Closing Disclosure no later than three business days before closing. Make sure to review everything and ask for clarification of anything you don’t understand. You may want to have a lawyer review the disclosure since, as we mentioned earlier, the terms of ARMs can be complex.
9. Attend the closing and pay closing costs. The final step is to attend the closing, sign all documents and pay your closing costs. You’ll need to bring a photo ID, proof of homeowner’s insurance and other documents to the closing as specified by your lender.

After you follow these steps, all that remains is to make your regular monthly payments. If you’re planning to refinance before the initial period ends, you’ll need to build home equity and keep your finances in order to make sure you can get an advantageous rate when the time comes.

Get an affordable ARM with Addition Financial

Adjustable-rate mortgages can be an advantageous choice provided that you understand how they work and when it makes sense to get one. Our guide can help you decide whether you are a good candidate for an ARM and get through the process of applying for one with minimal stress.

Are you in the market for an adjustable-rate mortgage? Addition Financial is here to help you! Click here to read about our ARM, which has no prepayment penalties and a conversion option after five years, and start the application process today.