8 Tips for Managing Adjustable-Rate Mortgages

Adjustable-rate mortgages offer some advantages to home buyers, particularly those who are buying a starter home or a property they plan to rehab and flip. The low initial rate may result in a lower monthly payment than a fixed-rate mortgage and can be advantageous for your finances—provided you know how to manage adjustable-rate mortgage terms and use them to your benefit.
At Addition Financial, we talk to our members all the time about various types of mortgages and help them decide which option is best for them. If you’re considering an adjustable-rate mortgage, we’ve put together this list of eight tips for managing adjustable-rate mortgages to help you make the most of your ARM.

What is an ARM?

An adjustable-rate mortgage, or ARM, is a type of home loan that has a low interest rate for an initial period that may last from six months to 10 years. After this period of fixed-rate payments, the interest rate will be begin to adjust every few months to a few years depending on the terms of the loan.

The initial period and adjustment periods vary from loan to loan and lender to lender. The most common loan structure for an adjustable-rate mortgage is 5/1, which translates to an initial period of five years and once-a-year adjustment for the remainder of the term. 

The interest rates for ARMs are determined by using an index such as the prime rate or the rate on US Treasury bills and adding a margin to it. Your personal credit, including your FICO score, income, and debt-to-income ratio, will be used to determine the margin your lender uses.

Many lenders cap interest rate increases, but that doesn’t mean you couldn’t end up paying more than you would with a fixed-rate mortgage, particularly if your initial period ends at a time of rising interest rates or your credit resulted in a high margin.

New call-to-action

8 tips for managing adjustable-rate mortgages

Adjustable-rate mortgages have more complex structures than fixed-rate mortgages, so it’s important to understand how to manage an ARM if you decide that getting one is the best choice for your circumstances. Here are eight tips to help you avoid some of the most common mistakes homeowners make with ARMs.

#1: Read the fine print

The most important tip we can give you about managing adjustable-rate mortgages is to read the fine print. When you apply for an ARM, you’ll receive a Loan Estimate within three business days of applying. Make sure to review it thoroughly, but keep in mind that the terms may change after the underwriting process.

You’ll receive a Closing Disclosure no later than three business days before your closing. Review it and address any questions or concerns immediately, so the lender can revise it if necessary. You should bring the Closing Disclosure to your closing and double check to make sure the terms match what’s in the loan documents. You may want to have a lawyer with you since the terms of ARMs can be complex and thus more confusing than the terms for a fixed-rate mortgage.

#2: Prepare for potential rate increases and/or refinancing

One of the features of an adjustable-rate mortgage is you will be notified when rate changes are coming. At the beginning of your loan term, there are some things you can do to prepare for potential increases, as well as things you can do to get yourself ready for refinancing.

You can prepare for potential rate increases by creating a budget that allows you to focus on saving money each month to help you cover higher payments. For refinancing, it may be worthwhile to review your credit, pay down your debt to decrease your DTI, and save some money to pay for closing costs.

#3: Early delinquency intervention

What happens if you’re nearing the end of your initial period and you’ve lost income or you know that interest rates are on the rise? A common reaction is to avoid addressing the problem until after your interest rate has increased, but there’s a better way to manage that situation if it happens to you: early delinquency intervention.

As soon as you know you’re not going to be able to afford your monthly mortgage payment, contact your lender. Lenders don’t want to foreclose on you. If you contact them immediately, you may be able to work out a forbearance agreement that allows you to make either a lower or no monthly payment for a set period. If you do this, keep in mind that later payments will need to be higher to make up for the forbearance.

#4: Loan modification

Another potential option if you can’t make your payments is requesting a loan modification. ARM loan modifications can translate to a lower monthly payment and the breathing room you need to avoid delinquency.

Some potential ARM mortgage modifications might include a reduction in your interest rate, a switch to a fixed-rate, or an increase in your loan term. Keep in mind that loan modifications are one potential element of an early delinquency intervention, and you’ll be most likely to get the help you need if you approach your lender before any delinquency occurs.

#5: Make extra payments toward the principal

One of the biggest advantages of having low monthly payments during the initial period of an ARM is that you may be able to afford an accelerated payment schedule that allows you to pay down the principal of your loan and reduce the amount of interest you pay going forward.

Before you start making extra payments, make sure to read your mortgage agreement carefully and check with your lender to clarify whether extra payments will go toward the principal or not. You should also make sure there is no early repayment penalty in place.

#6: Refinance

Adjustable-rate mortgage refinancing is popular because if you can afford to refinance before the initial period ends, you can take advantage of the low initial mortgage rate without getting stuck with a higher payment when it ends.

If you decide to refinance your ARM, keep in mind that you’ll need to be in your home for at least six months and have a minimum of 20% home equity to qualify. You’ll also be on the hook for closing costs, so make sure to factor those into your decision when the time comes.

#7: Sell your home and move

Selling your home might seem like an extreme option, but if you can’t qualify for refinancing it might be your best choice if you’re worried about your adjustable-rate mortgage monthly payments. Selling will help you get out of the ARM and avoid potential interest rate increases and you may be able to qualify for a fixed-rate mortgage instead.

Of course, if you’re going to sell, you should make sure your finances are in order. If you can’t qualify for a new mortgage to buy another house, then you may be better off staying where you are and pursuing either a forbearance or a loan modification instead.

#8: Get an ARM with a conversion option

If you’re considering an adjustable-rate mortgage, one thing you may want to do is find a lender that offers a conversion option in the contract. A conversion option allows you to convert the ARM to a fixed-rate loan when the initial period ends.

An ARM conversion has a lot in common with refinancing but you won’t have to pay closing costs. That said, there are fees associated with mortgage conversions and your interest rate will go up because the conversion will be influenced by market conditions. We suggest making a comparison between conversion rates and refinancing to determine which option is right for you.

What happens when an ARM loan resets?

If you have or are considering an adjustable-rate mortgage, you may have heard a mention of your ARM loan resetting. This term refers to the sometimes-sizable rate adjustment that happens when the initial period ends.

Many ARM loan agreements have caps on rate increases, including caps on periodic increases and lifetime increases. The increase after the initial period ends may also be capped but it is usually not applied to the lifetime cap. The result is that many homeowners with ARMs are hit with a significant increase due to changes in market conditions.

The most important thing to remember if you have an ARM is that initial increase. You know when it’s coming because you know how long the initial period is. With a five-year initial period, you have plenty of time to prepare for the initial increase. As we have noted above, your preparations may include saving money to pay for increases, refinancing or conversion. You can estimate your increase in the months leading up to the reset date by reviewing interest rates and in particular, the index your lender will use to make the adjustment.

5/6 arm

Get an adjustable-rate mortgage that works for you

Adjustable-rate mortgages can be helpful for some home buyers but it’s essential to know how to manage an ARM so you don’t make mistakes that negatively affect your finances. The eight tips we’ve included here will help you avoid errors and make the most of your ARM.

Are you in the market for an adjustable-rate mortgage? Addition Financial is here to help, with an ARM that includes a conversion option to make it easy to switch to a fixed-rate loan after your initial period ends. Click here to learn more and apply today.

The content provided here is not legal, tax, accounting, financial or investment advice. Please consult with legal, tax, accounting, financial or investment professionals based on your specific needs or questions you may have. We do not make any guarantees as to accuracy or completeness of this information, do not support any third-party companies, products, or services described here, and take no liability or legal obligations for your use of this information.