Is an adjustable rate mortgage a better fit for you?

Adjustable rate mortgages, and hybrid ARMs are becoming more and more popular with home buyers, because of their flexibility, and short-term money saving possibilities.

This page:

  • Explains how an adjustable rate mortgage works

  • Describes the various ways an ARM can save you money

  • Helps you decide whether an ARM is right for you.

Later in this section we discuss sub prime mortgages for those with "problem credit".

The second part of this Mortgage Basics Guide describes what goes into your mortgage package such as points, insurance, etc.

Would an adjustable rate mortgage be a better fit for your future plans?

An adjustable rate mortgage is based on a certain market index, however, unlike with an FRM, the interest rate you pay on an ARM changes over time with the index rate.

Your lender will specify the index rate and margin when you apply for your mortgage. The margin remains constant over the life of the loan, and your payments change only as the index rate does. Some common index rates used are short term Treasury Bill rates, the LIBOR, and the COFI.

An ARM's interest rate can change quite a bit during the life of your mortgage, depending on the behavior of the index rate. Usually (though not always) the interest rate you pay is adjusted once annually. This means your monthly payments will remain stable during the year and are adjusted at the end of it. This can be a dramatic change if rates steadily rise or fall over the course of a year.

Traditional ARMs feature an initial low fixed rate period of one year, followed by annual adjustments every year after for the life of the loan.

"Hybrid ARMs", also called "combination loans", are increasingly popular now, with initial fixed-rate periods of either 3,5, or 7 years, followed by annual rate adjustments for the remaining life of the loan.

Some lenders list these loans separately as hybrids, but most lump them together with ARMs. A hybrid 30-year ARM with a 7 year fixed period and annual adjustments for the last 23 years may be written as a 7/1 ARM, a 7/23 ARM or a 30-year ARM (7 Fixed). They're all the same mortgage.

Sidebar
Our recommended prime lender Eloan offers all kinds of hybrid ARM rates, all with Eloan's lowest rate in the country guarantee. If your credit is shaky, or if you have little money for a down-payment, you can get pre-approved at FullSpectrum in just a few minutes for the lowest sub prime rates anywhere.

Why would anyone want to assume the risk of a changeable rate?

Because the initial rate on ARMs is often set artificially low (lower than they would be on an FRM tied to the same interest rate). So, you'll be saving money (sometimes a lot) during the beginning of your mortgage.

Moreover, if you make larger payments (equal to payments under a corresponding FRM), you'll save thousands over the life of your loan. The extra money is applied to your balance and reduces your interest costs at the end of your loan.

One general rule to keep in mind about hybrid ARMs is that the shorter the initial fixed-rate period, the better the deal you'll get on the initial rate. The longer the fixed period, the closer the initial rate will be to a rate on a similar FRM.

So how do you know if an ARM is right for you?
Generally, you should choose an adjustable rate mortgage if you can see yourself in one of the following categories:

  • You plan on moving within 5-10 years.

  • Your salary is rising.

  • You need approval for a large loan amount.

  • Rates are high but you want to buy

Choosing between a fixed or adjustable-rate mortgage is a huge and important decision. For a more detailed look at the ARM vs. FRM question, visit our guide to choosing the right mortgage.

For those with more specific needs, check out our section on special mortgages. We explore mortgages for those with poor credit, low down payment, or large loan requirements.


Next: Sub prime mortgage for those with "problem credit"

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