Selecting the type of mortgage (ex. adjustable rate mortgage) you need to cover the expense of a new home can be difficult. There is a lot of confusing financial jargon to sort through. This makes it especially difficult when the type of mortgage sounds like financial jargon. Sometimes the process can give you a headache, but we hope to make the process easier.
An Adjustable Rate Mortgage
If you break the term down to two parts you get, ‘adjustable rate’ and ‘mortgage’. This makes it a little bit easier to understand the terminology. The words ‘adjustable rate’ communicates that the loan’s rate adjusts. But what does this mean?
A fixed-rate mortgage offers the same interest rate for the duration of the loan. In contrast, an adjustable-rate mortgage will change the interest rate. The loan is introduced with a low-interest rate for at least the first three years. Sometimes this rate will persist through the first ten years of the mortgage.
After this ‘fixed’ period the rate will periodically adjust. Often, you will know the time period between adjustments and the lender will always inform you when there is a change related to your mortgage.
How Does This Adjustable Rate Work?
As we’ve said, the adjustable-rate mortgage offers a ‘fixed’ rate for an introductory period. After this period closes the rate will adjust periodically. The amount the rate changes depends on a few different things.
The adjusted rate will increase or decrease based on market rate changes. This rate is based on your loan’s terms and the ‘benchmark’ rate. The ‘benchmark’ rate is an interest rate determined by your loan lender.
The Benefits of An Adjustable Rate Mortgage
If you’ve read this far, you are likely thinking that this mortgage option sounds risky. You are correct, there are risks related to accepting an adjustable-rate mortgage. But, there are quite a few benefits as well.
Flexibility
The adjustable-rate mortgage offers a home buyer some flexibility. These mortgages generally have no early-payment fees. This means that selling the home is easy and could save you some money.
This mortgage offers the buyer lifestyle flexibility. If you sell your home, there are very few strings attached in relation to the mortgage.
Low Payments
A home buyer could also benefit from the low payments. The introductory phase features a very low-interest rate. This low rate results in lower monthly payments. Throughout the lifespan of the mortgage loan, there may also be periods where the interest rate is lower.
Rate and Payment Caps
An adjustable-rate mortgage also features rate and payment caps. These caps control how high the interest rate can go, as well as, how high the monthly payment can be. This is necessary to ensure that the mortgage payment does not go over the home buyer's budget.
There are also caps on how much the interest rate can increase. These caps apply each time the rate adjusts. There is also a cap on how much the interest rate can change over the course of the loan term.
The Downsides of An Adjustable Rate Mortgage
For every benefit, there is always a downside. This is the case with this type of mortgage. There are a few downsides that must be considered to ensure that an adjustable-rate mortgage will work for you.
Higher Payments
After the introductory period, your payments may increase. This will add to your monthly expenses and can be hard to plan for. Whenever unexpected expenses occur it can cause stress. It is important that you acknowledge this risk and plan accordingly.
Even after careful planning, it can still be difficult to ensure that you can make the monthly payments. Losing your home is a risk if you are unable to make the higher payments after the introductory period.
Prepayment Penalty
It is important to remember that not every adjustable-rate mortgage will carry a prepayment penalty. But, some will. Talk to your loan lender before signing your paperwork. It is important that you understand every detail of the loan.
This is especially true regarding the prepayment penalty. This penalty could prevent you from selling or refinancing the home when you want to.
Confusing Terms
We cannot stress enough how important it is to understand the terms of your mortgage. Adjustable-rate mortgages are very complicated. The fees, rules, and regulations are very confusing. This is a huge risk if you don’t enter the agreement with your eyes wide open.
When to Consider An Adjustable Rate Mortgage
After reading all of the benefits and risks associated with an adjustable-rate mortgage, you are likely wondering when to consider this mortgage. When is the mortgage worth the risk?
An adjustable-rate mortgage can be worth the risk in some instances. If you are well prepared for the financial ups and downs you could save a great deal of money with an adjustable-rate mortgage.
This mortgage is also beneficial if you plan on relocating before the introductory period is over. You could take advantage of the low introductory rate and sell before the rate is over.
The Takeaway
Regardless of the mortgage you choose, there are risks. A mortgage is a long term commitment. You are fully responsible for the amount owed on the loan. The value of the home may change, but this will not affect the amount owed on your mortgage.
Buying a home is a big deal. Take the time to fully understand the options available to you. Consult with your lender and financial advisor when determining which type of mortgage you should accept. Congratulations on making the first step!
