Most people require financing in order to be able to afford a home. Typically, this financing comes in the form of a loan from a bank or mortgage lender. Since it has long since been the standard form of home loan, financing from these types of institutions is usually referred to as a ‘conventional loan.’ There is actually a bit of variety within the category of conventional loans, so you’ll need to do your homework before deciding which type of conventional loan is best for you. It’s recommended that you find a real estate law firm in your area and speak with one of the attorneys there – they should have insight into the best loan for you. In this article, we’ll be discussing the basics of one type of conventional loan in particular: the Adjustable Rate Mortgage (‘ARM’).
Characteristics of an ARM
An ARM, as you might have inferred from the name, is a conventional mortgage with an interest rate that fluctuates periodically during the life of the loan. Generally, the interest rate of your mortgage will change according to an index selected by your lender. Treasury securities are commonly used as indices in ARMs. Your lender will select intervals at which your mortgage’s interest rate will go up or down according to the chosen index. Let’s clarify this with an example:
You are approved for an ARM with Lender A. Lender A selects a one-year Treasury security as the index, and sets it to increase or decrease at annual intervals. This means that once a year, the interest rate of your mortgage will increase or decrease based on the one-year Treasury security’s performance.
The Pros of an ARM
One of the biggest advantages of an ARM is the up-front savings to the borrower. At the beginning of your mortgage, an ARM will typically an interest rate lower than a typical fixed-rate loan. This makes ARMs the ideal option for buyers who only plan to live in a house for five or fewer years. For up to five years, your interest will be capped at this lower rate, meaning that you’ll save big on your mortgage if you then sell and move out before five years is up.
If you keep your ARM for a longer period of time – such as continuing to live in the house you financed with it until the loan is paid off – you will enjoy the benefit of lower monthly mortgage payments whenever your interest rate decreases or remains low.
Finally, you may be able to negotiate for the inclusion of a conversion privilege in your ARM. A conversion privilege is simply the ability for you to convert your ARM into a fixed-rate mortgage after a set amount of time. This can allow you to enjoy the early savings of an ARM and then obtain the certainty and stability of a fixed rate mortgage later on.
The Cons of an ARM
All of the pros of an ARM have a negative flip-side. For instance, the initially low interest rate of an ARM eventually increases to a rate equal to or greater than that of a fixed-rate loan. In addition, while borrowers will enjoy lower mortgage payments when their interest rates decrease, they’ll see a jump in their payments when their interest rate goes up.
Another important risk to be aware of is the inclusion of prepayment penalties. In some cases, lenders will require borrowers to pay a substantial fee if they pay their mortgage off early. This is meant to penalize borrowers who utilize an ARM for a short period of time in order to take advantage of the lower introductory interest rate and then sell their home within five years before their rate increases. If you’re planning to utilize an ARM for the short-term, make certain (and ask your lawyer to check) that your loan agreement doesn’t contain a prepayment penalty clause.
An ARM can be a useful tool for borrowers in particular circumstances, but if you don’t understand how it works it can also be a financial pitfall. Be aware of the above points, and speak with a lawyer familiar with mortgages before committing to a loan.