What are the advantages of an adjustable-rate mortgage?
The type of mortgage that your clients choose for their home can have a major impact on their long-term perspective on the purchase. And no single type of mortgage is right for everyone.
Understanding what makes an adjustable-rate mortgage attractive can go a long way toward providing useful, relevant advice to your clients. Use this information to offer informed guidance if your clients have questions about adjustable-rate mortgages and if that option is right for them.
What is an adjustable interest rate?
An adjustable interest rate, in the context of loans like mortgages, is an interest rate that isn’t set in stone. Instead of deciding on a fixed interest rate before issuing a mortgage, the lender will adjust it periodically over the life of the loan.
The terms can vary significantly from one loan to the next, and often include a fixed interest rate to start before moving into the adjustment period. A 5/1 adjustable-rate mortgage (commonly abbreviated to 5/1 ARM), involves a five-year term with a fixed interest rate. Once that term expires, the rate will change on a yearly basis.
What factors affect an adjustable-rate mortgage?
Both the performance of the economy and the lender’s interest in benefitting from issuing a home loan affect an adjustable-rate mortgage.
The interest rate of an ARM includes two major factors: the index and the margin.
The index is a benchmark interest rate that reflects general economic conditions, as the Consumer Financial Protection Bureau explained. There are several indices that lenders can choose to use, but they generally reflect the same information.
The other element is the margin. This is an additional number of percentage points added to the loan by the lender as a way to earn money on their investment. The CFPB pointed out that borrowers can and should compare margins between different lenders. Additionally, the margin can sometimes be negotiated in the borrower’s favor.
Do conventional mortgage loans have fixed rates?
The short answer is yes. Lenders like banks offer conventional loans with both fixed and adjustable interest rates.
A conventional mortgage loan is simply a loan offered entirely through a lender, such as a bank or other financial institution. It contrasts with the various loans supported by government agencies like the Federal Housing Administration, among others.
How often does an adjustable-rate mortgage adjust?
Adjustable-rate mortgages can adjust on many different schedules, based on the terms set by a lender.
A yearly change after the introductory fixed-rate period expires is common, but not the only approach used by financial institutions. They could change on a quarterly basis or once every set number of years. It’s crucial that your clients understand that they need to discuss the frequency of the rate adjustment with their lender to build a more complete understanding of their loan.
Is an adjustable-rate mortgage a good idea?
An adjustable-rate mortgage can be a good idea if it aligns with the goals, financial position and interests of the buyer. It can be a bad idea for the same reason.
Because home buyers have many different reasons for purchasing a home, from a temporary living space or vacation destination to a place they plant to live for decades, it’s impossible to say that an adjustable-rate mortgage is always a good or bad idea. What can help is looking at the key circumstances that make such a loan a good or bad idea.
An adjustable-rate mortgage may be a good idea if:
- The home buyer believes interest rates or general market conditions will drop in the near or medium-term future, which would lead to a lower mortgage payment each month.
- The buyer only wants to own the property for a short period of time. The fixed portion of an adjustable-rate mortgage – like the five-year period in the 5/1 ARM we previously discussed – often offers a low interest rate, as the Motley Fool detailed.
An adjustable-rate mortgage may be a bad idea if:
The buyer believes interest rates or general market conditions will rise after their introductory, low-rate period ends.
- The buyer values consistency and doesn’t want to contend with the possibility of higher interest rates and larger payments in the future.
- Similarly, the buyer has found a low fixed interest rate offered by a lender.
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