December 1, 2022

Understanding Adjustable-Rate Loans

An adjustable-rate mortgage is a mortgage loan program where the interest rate can change at various points throughout the life of the loan. They differ from traditional fixed-rate mortgages. When the interest rate can change is outlined in the agreement between the lender and the borrower at closing. 

One of the major benefits of an adjustable-rate loan is the introductory rate is usually lower than a traditional fixed-rate mortgage. This means the ARM loan can allow the borrower to buy more house with the same down payment than they could with a fixed-rate mortgage. 

Borrowers can plan for rate increases because they will be scheduled into the mortgage, but the amount of the increase is subject to market fluctuations. This means the borrower might refinance the property to a fixed-rate mortgage before the interest rate is scheduled to adjust.

How an ARM Loan Works

An ARM loan rate is typically tied to an index such as the Wall Street Journal Prime Rate.

The rate of change and interest rate calculations can be found in the ARM Loan Agreement:

• An ARM loan rate is typically tied to an index such as the Wall Street Journal Prime Rate. 
• The rate of change and interest rate calculations can be found in the ARM Loan Agreement.
• An initial rate is disclosed, and the term that rate will be in effect. For example, Initial Rate 5% for the first 5 years of the loan.
• The terms and conditions of adjustments are defined:
  • After the initial 5 years, the loan rate will be the WSJ Prime rate plus a .5% margin. For example, WSJ Prime Rate 5.5% + .5% Margin = 6%.
  • The rate will change every year after the fifth year. This would be called a 5/1 ARM. The first number is the term of the introductory rate and the second is the frequency of subsequent changes.
  • Other terms include:
    • A maximum increase which prevents any single change from being above an agreed upon percentage.
    • A maximum increase for the life of the loan. To prevent the interest rate from reaching too high over the life of the loan. Often referred to as the ceiling.
    • A minimum interest rate which the loan cannot drop below. This is called the floor.

When should a borrower consider an ARM Loan?

There are several types of borrowers who would benefit from an adjustable-rate mortgage.

• Borrowers who move frequently for their jobs but still want to take advantage of the tax benefits that come with homeownership.
• Borrowers who work in careers which experience sustained upward mobility.
• Home flippers also prefer ARMs because of the lower introductory rates.
• Borrowers who wish to pay off their mortgages quickly. The lower rate allows for extra money to pay toward the principal.

What you need to apply:

• Most recent paycheck stubs and W-2s
• Bank statements for the last 2 months
• Most recent 2 years of tax returns