What is it?
An adjustable rate mortgage starts with a fixed interest rate for a pre-determined period of time. After that period is over the loan switches to its adjustable phase. During this time, the interest rate can go up or down, or remain the same, depending on the market rate at the time. So, if you have a 5/1 ARM, you'll have a fixed-rate mortgage for the first five years. After that, your interest rate will adjust every year. Most adjustable rate mortgages include an adjustment cap, which is the limit to how much a variable rate can change in a given adjustment period during the life of the loan. That cap ensures if there's a ten percent increase in interest rates over the course of the year, your loan's interest rate won't jump by that much.
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Advantages of an ARM
- The initial interest rate might be lower than what you could get with a fixed-rate loan. You may be able to get a bigger loan or lower payments than you could with a fixed-rate loan.
- If interest rates drop over the life of your loan, you'll benefit from lower payments.
- Lower initial payments mean you can invest your money someplace besides your house.
Disadvantages of an ARM
- It's hard to predict how interest rates will change in the future, so your payments might go up a lot over the life of your loan.
- The loan is harder to understand for first-time buyers than a fixed-rate mortgage. So you may end up paying more than you expected.
- There's not always an annual cap on your first interest adjustment. Depending on the current rates, you might end up with a big increase in your payments.
Is it right for you?
Adjustable rate mortgages are great for people who:
- might not stay in the house for very long
- lack the credit score, employment history, or other factors to qualify for a favorable fixed rate
- want to refinance before the initial interest adjustment