An adjustable-rate mortgage (ARM) is a type of home loan in which the interest rate can change periodically, usually in response to changes in a benchmark interest rate index. The initial interest rate is usually lower than for a fixed-rate mortgage, but the rate can increase or decrease over time, which can result in a higher or lower monthly mortgage payment. ARMs typically have a cap on how much the interest rate can increase or decrease at each adjustment, as well as a lifetime cap on how high the rate can go. This type of mortgage is often chosen by borrowers who expect to sell their home or refinance before the interest rate adjusts.
For Instance, A borrower obtains a 3/27 ARM loan of $250,000 with an initial fixed rate of 3.5%. For the initial three years, the borrower’s monthly mortgage payment would be $1,123. However, if after those three years, the benchmark interest rate is 3% and the bank’s margin is 2.5%, this results in a fully indexed rate of 5.5%. In this scenario, if the borrower still holds the 3/27 ARM loan and has not switched to a different mortgage, their monthly payment would increase to $1,483, which is an additional $360.
ARM Prepayment Penalties
An adjustable-rate mortgage (ARM) may have a prepayment penalty, which is a fee that a borrower must pay if they pay off their loan before the end of the loan term. The purpose of a prepayment penalty is to compensate the lender for the loss of interest income that would have been earned if the borrower had continued to make payments for the full term of the loan.
Prepayment penalties are typically calculated as a percentage of the outstanding loan balance or as a flat fee. They may also be based on a combination of the two. The percentage or flat fee will vary depending on the lender, the terms of the loan and the time remaining on the loan. Typically, the longer the time remaining on the loan, the higher the prepayment penalty.
It’s important to review the terms of the loan and understand if there is a prepayment penalty before signing the loan agreement. Some states have laws that limit or prohibit prepayment penalties.
pros and cons of 3/27 Adjustable-Rate Mortgage (ARM)
The pros and cons of a 3/27 Adjustable-Rate Mortgage (ARM) include:
- Lower initial interest rate: The initial interest rate on an ARM is typically lower than the rate on a fixed-rate mortgage, which can result in lower monthly mortgage payments for the first three years of the loan.
- Lower interest rate risk: Because the interest rate can adjust after three years, borrowers who expect to sell their home or refinance before the interest rate adjusts may benefit from an ARM.
- Lower closing costs: ARMs often have lower closing costs than fixed-rate mortgages, which can make them more affordable for borrowers.
- Higher interest rate risk: If interest rates rise, the interest rate on an ARM will also increase, which can result in a higher monthly mortgage payment. This can be a significant risk if the borrower plans to stay in the home for a long time.
- Uncertainty: The future interest rate is uncertain, so it is difficult for the borrower to predict their monthly mortgage payments, making budgeting and planning more difficult.
- Higher long-term costs: Even if the interest rate does not increase after the initial three years, the interest rate on an ARM will typically be higher than the rate on a fixed-rate mortgage over the long term, which can result in higher total interest costs over the life of the loan.
It’s important to consider your personal circumstances and long-term plans when deciding whether an ARM is the right type of mortgage for you. It’s also important to be aware of the terms of the loan and any prepayment penalties that may be associated with it.