Adjustable-rate mortgages (ARMs) can be valuable financing options for homebuyers in certain situations compared to conventional fixed-rate loans. Rate caps and limits define the benefits homebuyers can expect by limiting payout and the risk. In some situations, ARMs can help homebuyers in their first few years of ownership; in others, they present unnecessary risks to their financial security.
This article explains the advantages and disadvantages of adjustable-rate mortgages to help homebuyers make profitable decisions about their financial future.
What is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage is a home loan with an interest rate that changes based on market performance and the individual loan terms. These mortgages are divided into two phases or periods. The first is the initial period when the interest rate is fixed at a lower rate and does not change, and the second is the adjustment period when the rate fluctuates with the market.
ARMs can benefit homeowners by providing a lower interest rate in the first few years of the loan, typically 5 or 10 years, depending on the terms. For example, 5/1 ARMs use a common adjustment interval where the initial period is 5 years and subsequent adjustments happen annually.
ARM rates do not consistently beat the market rates for conventional fixed-rate loans. Oversaturation and market performance can force ARM interest to be higher than fixed loans even in the initial period, eliminating their primary benefit. Homebuyers should ask their prospective lenders about the ARM rates compared to fixed-rate loans to determine whether the rate in the initial period justifies the risk later.
What are Rate Caps?
Rate caps limit interest rate increases and decreases on ARMs, mitigating the risk that homeowners take on after the initial period. In a severe market decline, the loan terms would stop the interest rate from rising past a certain point. There are three different caps that homeowners should know about:
- Initial caps limit the rate increases at the first adjustment
- Periodic caps limit the amount the interest can increase between adjustment periods
- Lifetime caps limit the amount the interest can change over the lifespan of the mortgage
Each cap is set separately by the loan terms and should be explained and understood before homebuyers opt for adjustable-rate mortgages. Since ARMs often provide lower initial payments than fixed-rate mortgages, they are favored by homebuyers who plan to move out of the home within the first few years. Rate caps are in place to prevent out-of-control interest from depriving homebuyers of this benefit.
Real-World Example of Rate Caps and Limits
To understand the practical implications of rate caps, consider this example of a 5/1 ARM with a 2/5/9 cap, using the approximate average home value in Maryland ($435,000).
A cap of 2/5/9 determines the rate change terms that bind the loan over the lifetime of the mortgage or until the rate is renegotiated. In a 2/5/9 cap, the initial cap at the first adjustment is limited to 2% above the initial interest, the rate can only change a maximum of 5% at the period adjustments, and the rate can never go above 9% past the initial rate for the lifespan of the loan (2/5/9).
Using the $435,000 mortgage for a 30-year ARM with a 2/5/9 cap starting at 5% interest:
- Initial principal and interest (5%): $2,336/month
- First adjustment (capped at 2%): $2,896/month (maximum)
- Period adjustments (capped at 5%): Payment depends on the rate change
- Maximum rate increase over the life of the loan (up to 9%): $5,147/month (maximum)
These are the worst-case scenarios for interest rate increases in this example. In many cases, ARMs adjust with market changes without reaching the cap; in others, the market may even dip below the initial rate. An ARM can be refinanced for a better rate or as a fixed-rate loan, but refinancing requires repaying some closing costs and fees.
Interest rates shift daily, so the benefits of an ARM on one day may be mitigated on the next. Speak with a financial advisor about the benefits and risks of an ARM in your situation and lock in an advantageous rate before the market shifts in the other direction.
Consult With Home Loan Professionals to Choose the Right Loan Type
Adjustable mortgage rates can benefit homeowners by offering a lower interest rate in exchange for a variable rate after the initial period. This can give homeowners more liquidity to settle into their new homes. Eventual market changes can increase or decrease interest on ARMs, but rate caps and limits mitigate the market risk that homebuyers are responsible for.
At Woodsboro Bank, our team of financial advisors helps homebuyers understand rate caps and limits to decide whether an ARM is the right choice for their home mortgage. Contact our team today to get started.