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Adjustable Rate Mortgages Explained
Mortgage rates have been historically low for a few years, but they are on the rise. As interest rates rise, variable rate mortgages often become more attractive to some homebuyers. With 30-year fixed rate loans at 4.67%, the highest interest rate since 2018, the rate on a popular adjustable rate mortgage is 3.5%.
As the name suggests, the interest rate a homeowner pays with an adjustable rate mortgage changes over the life of the loan. After an introductory period, during which the rate is fixed and usually lower than that offered by a fixed rate mortgage, the rate can go up or down. And that carries risks.
Borrowers shunned adjustable-rate mortgages after the housing market crash of 2008, but guidelines put in place since then require lenders to consider homebuyers’ ability to repay mortgages on the full loan , and not just at launch rate. In 2022, interest rates are rising as house prices continue to soar, so the centralized banking system in the United States – its Federal Reserve – has raised a key interest rate in an attempt to rein in the ‘inflation.
To explain the mortgage market, real estate platform ZeroDown has compiled a list of facts about adjustable rate mortgages, including what they are, how they differ from fixed rate mortgages, what factors affect interest rates and the monthly payments of an adjustable rate mortgage, and who can benefit from this type of mortgage loan.
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Differences between adjustable rate mortgages and fixed rate mortgages
The main difference between a variable rate mortgage and a fixed rate mortgage is in the names: a rate that changes and adjusts versus a rate that remains fixed and static. The interest rate paid on an adjustable rate mortgage can go up and down, while that of a fixed rate mortgage is determined when the loan is taken out. It will not change during the term of the loan. A variable rate mortgage will usually start at a lower rate than a fixed rate mortgage during an introductory period, but after that period the rate fluctuates. Depending on the mortgage chosen, the introductory period can last as little as one month, or up to five years or more.
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Components of an Adjustable Rate Mortgage
Adjustable rate mortgages have a number of components, including an introductory interest rate period, index, spread, interest rate caps and payment caps. Once an introductory period ends, the interest rate is determined by adding a spread to an index. These margins, which are agreed at the time of the loan application, may vary depending on the lender, and the interest rate changes as the index fluctuates.
Some common indexes include one-year constant maturity treasury rates, the cost of funds index, and the overnight guaranteed funding rate. An interest rate cap, either annually or over the term of the loan, provides some protection against large changes in interest rates. A payment cap can limit the amount that monthly payments increase with each adjustment.
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Types of Adjustable Rate Mortgages
Anyone considering an adjustable rate mortgage can choose from several different types. A hybrid variable rate mortgage offers a mix of fixed and variable rate terms, for example, one that offers five years of a fixed rate after which it could adjust every year. This would be described as a 5/1 variable rate mortgage, with the first number referring to the fixed rate term and the second number indicating how often the rate can be adjusted each year after the fixed rate term ends. .
With an interest-only variable rate mortgage, only the interest can be paid for a certain number of years, usually three to 10 years, giving the borrower a smaller monthly payment over that period.
A variable rate mortgage with payment option offers the flexibility to choose the type of payment to be made each month. The choices are usually a payment of principal and interest; an interest-only payment; or a minimum or limited payment which may not cover interest, the difference being added to the principal of the loan.
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Who should get an adjustable rate mortgage?
Variable rate mortgages carry more risk after the introductory period is over if interest increases, which can make budgeting more difficult. That said, adjustable rate mortgages can be a good idea for homeowners who plan to stay in their home for a shorter period of time. If, for example, you’re in the military or have a contract with an employer and plan to move after about five years, you’ll only pay the lowest introductory interest rate.
Or, with a lower interest rate, you might be able to pay off more of the principal more quickly, assuming the mortgage doesn’t include prepayment penalties. If you plan to sell your home or refinance in the future, watch out for repayment penalties.
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How rising interest rates can affect mortgage payments
In March 2022, the Federal Reserve announced a quarter-percentage-point increase in its key rate, which is the interest banks can charge for overnight loans. The Federal Reserve has also indicated that to curb inflation, further hikes are likely before the end of the year. Since many adjustable rate loans are now tied to the Overnight Guaranteed Funding Rate and this rate is affected by the decisions of the Federal Reserve, these mortgage rates will go up or down.
With the average rate on a 30-year fixed rate mortgage well above the average rate on a 5/1 adjustable rate mortgage, for example, the adjustable rate mortgage seems more attractive to many buyers. Remember, however, that an adjustable rate mortgage carries more risk once the introductory period has expired.
This story originally appeared on ZeroDown
and was produced and distributed in partnership with Stacker Studio.