Adjustable-Rate Mortgage: What Happens When Interest Rates Go Up

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Adjustable-Rate Mortgage: What Happens When Interest Rates Go Up

Borrowers may save a lot of money on interest rates over the short- to medium-term with adjustable-rate mortgages (ARMs). However, if you still have one when the interest rate resets, your monthly mortgage payment can increase significantly. That’s good if you can afford it, but if you’re like the overwhelming majority of Americans, it could be difficult to accept a rise in your monthly payment.

What is an Adjustable Rate Mortgage?

Think about this Part of the reason why so many individuals were driven into foreclosure or were had to sell their houses in short sales during the financial crisis may be attributed to the reset of adjustable-rate mortgages. Many financial advisers classified adjustable-rate mortgages as dangerous after the housing crisis. Although the adjustable-rate mortgage (ARM) has a terrible reputation, it’s not a horrible mortgage product as long as consumers are aware of what they are signing up for and what occurs when an ARM resets.

Key Takeaways

  • In an adjustable-rate mortgage (ARM), the interest rate charged on the outstanding amount changes throughout the course of the loan.
  • Borrowers with ARMs should anticipate paying higher monthly mortgage payments as interest rates rise.
  • On a predetermined timetable, often yearly or semi-annually, the ARM interest rate resets.
  • There are restrictions on how much the interest rates and/or payments may increase each year or over the course of the loan with adjustable-rate mortgage caps.

Interest Rate Changes with an ARM

You must first comprehend how an adjustable-rate mortgage works in order to have a clear understanding of what is in store for you. Borrowers who choose an ARM secure an interest rate for a certain length of time; this rate is often low. The mortgage interest rate resets to whatever the current interest rate is after that period is through. The Federal Home Loan Mortgage Corporation, or Freddie Mac, states that the first time during which the rate is stable spans from six months to 10 years. The interest rate a borrower pays (as well as the size of the monthly payment) for various ARM products may rise significantly throughout the course of the loan.

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Borrowers may find it appealing due to the initial cheap interest rate, especially those who don’t intend to live in their houses for an extended period of time or who are savvy enough to refinance if interest rates rise. Due to historically low interest rates, borrowers who had an adjustable-rate mortgage reset or altered didn’t see a significant increase in their monthly payments. However, depending on how soon and by how much the Federal Reserve increases its target rate, things might alter.

Know Your Adjustment Period

Borrowers must comprehend the fundamentals regarding ARMs in order to decide if they are a suitable match. The adjustment period is essentially the interval between changes in interest rates. Take an adjustable-rate mortgage with a one-year adjustment period as an example. A 1-year ARM would be the name of the mortgage product, and the interest rate—and therefore the monthly mortgage payment—would fluctuate once year. It is known as a 3-year ARM and the rate would vary every three years if the adjustment period was three years.

There are also some hybrid options available, like as the 5/1 year ARM, which offers a fixed rate for the first five years before adjusting once a year after that.

Understand the Basis for the Rate Change

In addition to understanding how often their ARM will alter, borrowers must comprehend the reason behind the interest rate adjustment. The one-year constant-maturity Treasury securities, the cost of funds index, and the prime rate are the three most popular indexes on which lenders base ARM rates. Ask the lender which index will be used and look into its historical volatility before taking out an ARM.

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Avoid Payment Shock

Payment shock, which occurs when the monthly mortgage payment increases significantly as a result of the rate adjustment, is one of the largest hazards ARM borrowers face when their loan changes. If the borrower cannot afford the new payment, this may result in hardship.

Keep an eye on interest rates as your adjustment time draws near to avoid experiencing sticker shock. Mortgage servicers are obliged by the Consumer Financial Protection Board (CFPB) to offer you an estimate of your new payment. You should get that estimate seven to eight months before to the adjustment if the ARM is resetting for the first time. If the loan has already altered, you will be informed two to four months in advance.

Additionally, with the first notice, lenders are required to provide you information on alternatives you may consider if you can’t afford the new rate as well as how to get in touch with a HUD-approved housing counselor. Knowing the new payment amount in advance can allow you time to plan for it, look about for a better loan, or obtain assistance determining your alternatives.

The Bottom Line

As long as you are aware of what will happen when your mortgage interest rate resets, taking out an adjustable-rate mortgage need not be a dangerous venture. With an ARM, the interest rate may fluctuate after a length of time and, in certain situations, it may climb dramatically, in contrast to fixed mortgages where you pay the same interest rate for the duration of the loan. You may avoid sticker shock by anticipating how much extra you’ll have to pay each month. More importantly, it may support your ability to make your monthly mortgage payment.

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