One of the crucial aspects you want to pay attention to when getting a mortgage is the interest rate. There are mainly two types of mortgage interests, namely fixed rate and adjustable rate. A fixed loan is paid at the same rate until it is fully paid off. An adjustable rate mortgage, hence the name, adjusts its rates over time. This PDS article explores adjustable rate mortgages, what they are, when to use them, and when not to use them.Â
What is an Adjustable Rate Mortgage? How They Work
An adjustable rate mortgage is a type of loan where individuals pay a different interest rate for a set period, followed by a new rate after a defined period. Usually, an adjustable rate mortgage will have a fixed interest rate at the beginning, then be adjusted after the fact.
A core benefit of adjustable rate mortgage rates is that they will usually be lower at the onset, and then fluctuate depending upon the external interest rates trends in the broader market. Nonetheless, the adjustable rate mortgage rates are capped so that the adjustment is not detrimental to the homeowner. Therefore, these mortgages are more often than not a suitable option if you are looking to save money in the short term.
Meanwhile, your adjustable rate mortgage – and, in effect, its variability over time – is affected by three main indexes:
- The Secured Overnight Financing Rate (SOFR)
- The one-year Treasury bill
- The 11th District cost of funds index (COFI).Â
The respective rates will be determined by the index that applies to your adjustable rate mortgage, in addition to the margin (note that the margin is stated as a percentage and will remain constant as the index rate changes). Insomuch as you are comfortable with your interest rates ebbing and flowing with market fluctuations, ARMs may be right for you.
When to Use an Adjustable Rate Mortgage
Now that we have defined an adjustable rate mortgage, let’s discuss when to use it. Specifically, there are five primary times to use an adjustable rate mortgage:
- You want to make lower monthly payments with a higher introductory rate.
- You are looking to improve your short-term cash flow.
- You are looking to refinance before the adjustment period concludes
- Â If you are selling before the fixed introductory rate period ends.
- If you plan to move or sell before the fixed rate period ends (generally 5-10 years)
- When there is a possibility of an increase in income.
When Not to Use an Adjustable Rate Mortgage
With that being said, an adjustable rate mortgage is not for everyone, and may not be suitable for specific individuals. The two most obvious cases as to when an individual should not use an adjustable rate mortgage is if:
- You are not able to confidently wave through and meet the demands of the ever-changing interest rate.
- The home is not a short-term purchase.
Can You Refinance an Adjustable Rate Mortgage?
Yes! It is one of the reasons why some people will opt for this type of mortgage. However, before you take on this loan, you should know that refinancing it is not free.
An adjustable rate mortgage (or ARM) is an excellent option if you meet the criteria and can be less costly than a fixed rate mortgage. Ensure that you talk with your lender to know how to qualify for this type of mortgage and what to do to make it more beneficial to you.
