When someone purchases a new home, they are faced with differing mortgage choices. The most significant decision is the choice between a conventional fixed-rate mortgage and a Houston adjustable rate mortgage (ARM). A fixed-rate mortgage carries the same interest rate throughout the period of the loan. An adjustable rate mortgage has fluctuating interest rates but offers definite benefits. However, ARMs can seem confusing at first.
How an Adjustable Rate Mortgage Works
The most important thing to know about the mortgage rate on an ARM is that it can be expected to raise or lower periodically during the life of the loan. This means that the monthly mortgage payment could go down or up. If the mortgage payment increased when someone was living on a very tight budget, it could be very difficult to make the higher payment.
Interest Rates are tied to an Index
A typical ARM would begin with a lower interest rate than a fixed-rate mortgage. The low rate usually lasts for five years. At a preset time, often once a year, the interest rate will rise or decrease according to whether or not a specified index has moved up or down.
The three major indexes most often used for ARMs are:
- The yield on one-year Treasury bills, the weekly constant maturity yield;
- The 11th District Cost of Funds Index (COFI), the interest rate paid on deposits in the western US;
- The London Interbank Offered Rate (Libor), the rate that one international bank will charge another on a large loan.
Interest Rate Trends
Interest rates change frequently but have generally decreased since 1984, when a Certificate of Deposit earned about 12%. CDs currently pay 1-2%. This has generally been beneficial for homeowners with ARMs. However, many economists expect interest rates to increase, so that should be considered when choosing adjustable-rate home loans.
Rate Increases are Limited
ARM home loans have caps that limit how much the interest rate—and the monthly mortgage payment—can increase. There are different types of caps:
- A periodic rate cap establishes a limit on how much the interest rate can change every year;
- A lifetime rate cap sets a limit on how much the interest rate can increase during the life of the loan;
- A payment cap sets a limit on how much the monthly mortgage payment can increase during the life of the loan. Some people prefer a payment cap since they like knowing exactly what the highest payment could ever be.
The Benefits of Adjustable Rate Mortgages
There are many advantages of adjustable rate mortgage loans.
- The initial period of the loan, usually three to five years, has a lower rate than a fixed-rate loan.
- If someone believes they will only own the home for a limited time, then a possible rate increase isn’t much of a concern. Military families, for example, can usually feel confident that they will be moving again in a few years.
- A disciplined homeowner could use the savings of a lower ARM mortgage payment for other purposes.
- A retiree or saver could make extra payments on the adjustable rate mortgage in Houston and pay it off at the lower ARM rate.
A Houston adjustable rate mortgage works very well for many homeowners. Before automatically choosing a fixed-rate mortgage, compare it to ARMs. Consider the impact of possible higher mortgage payments in the future as well as the benefits of lower mortgage payments now and possibly later. Take the time to choose the mortgage that will work the best for you.