Most lenders today offer a fixed-period or “hybrid” ARM,—which is an adjustable-rate mortgage that features an initial fixed interest rate period, typically of 3, 5, 7, or 10 years. After the fixed-rate period expires, the interest rate becomes adjustable for the remainder of the loan term. Fixed-period ARMs are often named by the length of time the interest rate remains fixed.
Example: In a 5/1 ARM, the “5” stands for the five-year “introductory period,” during which the interest rate remains fixed. The “1” shows that the interest rate is subject to adjustment once per year after the introductory period and for the remainder of the loan term.
About the introductory period: The rate on this kind of loan tends to be lower during the introductory period, which could mean a lower starting monthly payment. However, when the introductory period ends, your rate will go up or down depending on changes in the financial Glossary Term: index Information Panel to which your loan is associated. If considering an ARM, carefully consider your ability to handle potential increases to your rate, and consequently, your monthly principal and interest payment.
Caps: ARMs have two kinds of Glossary Term: rate caps Information Panel. Glossary Term: Adjustment caps Information Panel limit how much your rate can go up or down in any single adjustment period, limiting how much your loan payment can change when it adjusts. Glossary Term: Lifetime caps Information Panel establish a maximum, and minimum, interest rate over the entire life of a loan. Many caps allow a significant increase in each adjustment period and over the life of the loan, so despite having a cap, the increase in the monthly payment allowable under the cap may still result in “payment shock.” Such an increase may make it difficult, or impossible, for you to pay your mortgage on time if interest rates rise. If you’re considering an ARM, find out what the caps would be and then run the numbers to see if you could still comfortably afford the monthly payments allowable under the rate caps.
Advantage
Hybrid ARMs generally offer lower rates during the introductory fixed rate period than fixed-rate mortgages.
Considerations
- After the introductory period’s fixed rate expires, the rate is subject to adjustment. The rate could increase at this point, which would also increase your payments. This can make paying your mortgage on time more difficult.
- If you choose this kind of loan, be sure it includes an adjustment cap and/or lifetime interest cap. Keep in mind that many adjustment or lifetime caps would still result in Glossary Term: payment shock Information Panel, which is a term used to describe a significant increase in your monthly payment. For example, if you had a 5/1 ARM with a starting interest rate of 4.0% (and interest rates rose) and your rate increased by 2 percentage points in the first two adjustment periods, by year 7, your interest rate would be 8.0% -- so your monthly payment would double from the starting monthly payment. So ask for details and plan accordingly.
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