An Adjustable-Rate Mortgage (ARM) loan is a mortgage with an interest rate that changes periodically, meaning your monthly payments can vary over the life of the loan. ARMs usually start out with a fixed interest rate for a specified period, usually 3, 5, 7, or 10 years.
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During this initial fixed period, your interest rate will remain unchanged. After this period, your interest rate will be adjusted periodically (annually, semi-annually, etc.) based on a certain index or benchmark and a margin set by the lender.
ARMs got a bad rap after the 2007-2008 housing crisis, when many couldn't afford the increased payments. But millions of homeowners have been on ARMs since 2019, and many of them are in an adjustment period. Already, 328,000 homeowners have reached the end of their fixed period, and another 102,000 will face the change next year, according to the Intercontinental Exchange.
CNN reports that Jennifer Hernandez was surprised when her monthly mortgage payments on her Houston home jumped by about $2,000 after she refinanced her home with an adjustable-rate mortgage in 2016. Unlike fixed-rate mortgages, adjustable-rate mortgages may seem like a better deal, but they come with risks that can surprise homeowners.
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Jennifer's ARM had a fixed rate for seven years. After that, the interest rate would adjust annually based on current market conditions. With interest rates reaching their highest levels in decades, many people with ARMs like Jennifer are now facing much higher monthly payments.
Jennifer, the loan officer, initially thought she was getting a 10/1 ARM (fixed for 10 years), but she actually got a 7/1 ARM (fixed for 7 years). Last October, her interest rate increased 2% to 5.125%, the highest allowed in the first year of adjustment.
Most ARMs have an interest rate cap to prevent excessive increases. In Jennifer's case, the cap is 8.125%, or 5 percentage points above her starting rate. She decided not to refinance because her fixed mortgage rate was still higher than her new adjustable rate. But she expects her monthly payments to increase even more this October.
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According to CNN, some loan officers are reporting a surge in applications for ARMs as borrowers hope the Federal Reserve will cut interest rates in the coming years and allow them to refinance before rates are reset. Currently, about 40% of high-cost loans are ARMs, saving borrowers hundreds of dollars each month.
ARMs are a great choice if you plan to stay in your home for only a few years or if you expect your income to increase: A lower initial interest rate makes your monthly payments more affordable and helps you save money in the short term.
However, in a few years, interest rates may rise, increasing monthly payments. It is important to be prepared for this possibility and tolerate the risk of fluctuations in payments. Above all, borrowers should not forget the terms they agreed to when they signed their mortgage many years ago.
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