Most homebuyers are familiar with the fixed rate mortgage. This is the type of financial instrument whereby the buyers make the same monthly payment each term, for the entirety of the loan. Once the homeowner makes the final payment, the house is theirs, and they are only responsible for the property taxes and any homeowners association fees on the home.
But there are many other types of mortgage options in the marketplace that deserve your attention. One size sometimes doesn't fit all. These other types of options are called ARM's. The acronym stands for "adjustable rate mortgage"
Due to the 2008 financial crisis, they sure do have a negative connotation. Many of those loans were interest only loans. Many of those homeowners never had any real equity, and when the markets crashed, they simply walked away from their responsibilities.
Before we get started, the only difference between an ARM and a conventional mortgage is that the interest rate of the former can change. This means your payment could go up or down.
The only reason to consider an ARM is due to its lower initial payment. The interest rate is always lower than its conventional counterpart. This rate is called the "teaser rate". They also have CAP's and Floors. More on that later.
Here are some of the more popular ARM's buyers can find today.
These types of mortgages will have in initial term where the interest rate is fixed. In this specific case, the monthly interest rate and payment won't change for the first 5 years. After the 5th year the rate will reset. It will reset every year, for the next 25 years, or until you pay-off the mortgage, sell, or refinance.
However, there are caps and floors involved. This will limit how much the rate can change each year, and over the life of the loan. Remember though, rates can also go down, potentially lowering your payment. Floors are in place so the lender doesn't lose money in this mortgage transaction.
The 5/5 ARM
The 5/5 is also a popular mortgage. The initial rate is fixed for the first 5 years of the loan. Then the rate will reset starting on the 6th year, and stay fixed for the next 5 years. This will occur 5 times, or every five years. The risk here is that the mortgage may reset higher on the 6th year, thus leaving the borrower with a higher monthly payment for 5 years. If rates happen to go back down, they will have to wait until the 11 year begins for the next reset.
There is also a 5-25. When it comes to adjustable rate mortgages, this may be one that buyers are more comfortable with. The "teaser rate" for this particular version is fixed for 5 years. There is just one adjustment that takes places on year 6, though the duration of the loan.
The 10/1 ARM
This type offers homeowners a full decade of fixed payments. Starting the 11th year, the rate will adjust. This will occur each year until the loan is paid off, refinanced. or the house is sold. This type of ARM is closer to a conventional than the majority of other options within this type of offering.
Who is attracted this type of loan? Many homeowners know well in advance that they will be moving before the fixed term has ended. Other buyers realize that they are the type that have lived in many homes, but usually never stay for 10 years.
Two Step Mortgage
The 2 step is very simple to understand. There an interest rate for one period of the mortgage, and another rate for that second term. Many buyers simply will sell their home before the adjustment hits.
Other buyers will be taking a risk that the second term doesn't bring an upward adjustment. All ARM's do carry some risk. But this risk can be alleviated in some ways.
A 1/1 ARM literally resets 12 months after the loan begins. This is not for the faint of heart. Renting an apartment might be a better alternative. Why take the risk? People who engage in 1/1's need to be savvy buyers. Maybe they feel the market will be substantially different in 12 months than it is today. They plan on selling and making a profit.
ARM's can be a great tool when applied to a specific life situation. If the buyer is aware that their company will be relocating them after 5 years, then a 5-1 ARM can be perfect.
Or suppose an individual knows for certain they will be making more money in the near future. They can absorb the higher payments if the rates do reset higher.
Or some buyers will just refinance before the "teaser period" expires. All are valid reasons why an ARM might make sense.