Interest rates change
Adjustable-rate mortgages (ARMs) have an interest rate that may change periodically depending on changes in a corresponding financial Glossary Term: index that’s associated with the loan. When the rate changes, generally, your monthly payment will increase if rates go up and decrease if rates fall.
Most lenders today offer a “hybrid ARM,” or “fixed-period ARM,” which features an initial fixed interest rate period, typically of 3, 5, 7 or 10 years. After the introductory fixed-rate period expires, the interest rate becomes adjustable for the remainder of the loan Glossary Term: term. The overall term for Bank of America hybrid ARM loans is 30 years. These loans are named by the length of time the interest rate remains fixed and how often the interest rate is subject to adjustment thereafter.
For example, in a 5/1 ARM, the “5” stands for a 5-year introductory period in which the interest rate remains fixed. The “1” shows the interest rate is subject to adjustment once per year after the introductory period expires.
How an adjustable-rate mortgage impacts payments
With a hybrid ARM, the interest rate during the introductory period is often lower, which could mean a lower starting monthly payment. However, at the end of the introductory fixed-rate period, the loan’s interest rate will adjust to a fully Glossary Term: indexed rate, and your rate and your monthly payments may increase. If that happens, you’ll want to be financially prepared to make larger payments.
Similarly, once a year after the introductory period is over and for the remainder of the loan’s term, your rate—and monthly payment—could go up or down.
Things to consider
Hybrid adjustable-rate mortgages are a good choice if you:
- Are planning to move in a few years (before the end of the introductory fixed-rate period) and therefore aren’t concerned about possible rate increases
- Expect your income to rise enough in the coming years to cover any increase in payments resulting from an increase in the interest rate
- Want a lower initial monthly payment than a fixed-rate mortgage usually offers
- Think interest rates may go down in the future
Some disadvantages of a hybrid adjustable-rate mortgage:
- Interest rates will increase in a rising rate environment
- An increase in rates will increase your payment amount, which may not keep pace with an increase you may have in income
- An increase in interest rate will reduce the accumulation of Glossary Term: equity, especially where home values are declining, and may make it more difficult to refinance your loan
Types of hybrid ARMs
10/1 adjustable-rate mortgage
A 10/1 ARM loan has a fixed interest rate for the first 10 years. After 10 years, the rate can change once every year for the remaining life of the adjustable-rate mortgage. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
7/1 adjustable-rate mortgage
A 7/1 ARM loan has a fixed interest rate for the first 7 years. After 7 years, the rate can change once every year for the remaining life of the adjustable-rate mortgage. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
5/1 adjustable-rate mortgage
A 5/1 ARM loan has a fixed interest rate for the first 5 years. After 5 years, the rate can change once every year for the remaining life of the adjustable-rate mortgage. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
ARM loan indices and interest rate caps
The interest rate you pay on a hybrid adjustable-rate mortgage after the introductory fixed rate expires is based on a fluctuating financial Glossary Term: index plus a Glossary Term: margin. Your monthly payments will increase if rates go up and decrease if rates fall. For example, if the interest rate for the financial index is 5.5% and your margin is 2.25%, then your rate at the time of adjustment would be 7.75%. Keep in mind that different indexes go up and down faster than others, and both the index used and the margin can vary among lenders. How often your payments are adjusted based on the index, and how much rates and payments increase at each adjustment, depends on your adjustable-rate mortgage terms.
Hybrid (as well as traditional) ARM loans typically feature an Glossary Term: adjustment “cap,” which limits how much the interest rate can go up or down in any new adjustment period and/or over the life of the loan. However, many rate caps allow significant monthly payment increases that could result in “payment shock.” After the introductory fixed-rate period, the interest rate for ARM loans adjusts once per year.
When finding out about ARM options, be sure to ask the following questions:
- Does the ARM loan you’re considering include a rate cap? If yes, what is the rate cap per adjustment period and over the life of the loan?
- How often is the rate subject to change?
- Is your ARM loan Glossary Term: assumable?
- Are there any penalties for paying off your loan early, also called a prepayment fee? Being able to prepay your adjustable-rate mortgage will allow you to refinance if rates go down.
Every adjustable-rate mortgage loan uses a money rate index to determine the loan rate for a set period. Lenders have no control over any of the money rate indices. You can track the performance of each index in The Wall Street Journal. The rate you pay is set at each adjustment period by adding the rate of the index plus your Glossary Term: margin (which remains the same from period to period). Below are some common indices on which adjustable-rate mortgages are based.Footnote 1
Even though rate indices may adjust more frequently than every year, Bank of America adjustable-rate mortgages do not adjust more frequently than once a year.
Treasury-indexed adjustable-rate mortgages (T-Bills)
These track the weekly average yield of U.S. Treasury securities adjusted to a constant maturity of 6 months or 1 year. The interest rate on an ARM loan from Bank of America will adjust once each year. Per-adjustment Glossary Term: caps and lifetime rate caps vary.
London Interbank Offered Rate (LIBOR) adjustable-rate mortgages
The LIBOR index tracks the rate international banks charge each other for large loans in the London interbank market. This adjustable-rate mortgage adjusts to the LIBOR annually based on the 1-year U.S. dollar–denominated deposits in the London market, as published in The Wall Street Journal.
Adjustable-rate interest-only loans
Note: Bank of America offers the interest-only payment option on jumbo loans only.
Adjustable-rate interest-only loans have a 30-year term and an initial time frame, usually 10 years, during which you can choose to make interest-only payments or both principal and interest payments. This means the initial payments are comparatively low, allowing you to use the balance of your cash flow for other immediate needs. At the end of the interest-only period, you will be required to pay both interest and principal so the outstanding balance will be paid in full over the remaining 20-year term of the loan.
While you’re paying only interest, your payments are not building potential home equity. By the end of the interest-only period you will still owe the original amount you borrowed, which may make it more difficult to refinance your mortgage or to make money from selling your home. If you paid only interest during the initial time frame, once the initial time frame expires your payments will be significantly higher and can result in “payment shock.” With an adjustable-rate loan, the interest rate on your loan is adjustable. As a result, if rates rise, so will your monthly payment. If this adjustment happens after the first 10 years of an interest-only loan, the monthly payment would rise even higher due to the requirement of paying principal and interest during the final 20 years of the loan. Be sure you fully understand the risks involved before committing to an interest-only loan and making interest-only monthly payments. Since this loan begins with an interest-only period, you will pay more interest over the life of the loan compared with a traditional 30-year mortgage.
Interest-only loans tend to appeal to people whose income fluctuates (those who are self-employed, on commission or on a bonus schedule) or who expect to own their home for a short period of time. The fixed-period ARM interest-only mortgages have initial fixed-rate periods of 3, 5, 7 and 10 years, and are adjustable annually thereafter.
A combination loan pairs a conforming first mortgage with a home equity Glossary_Term: second mortgage for up to 80% of the property’s value in a single application with 1 down payment. Combination loans may help you avoid the higher rates of a jumbo first mortgage. Combination loans are made up of 3 parts:
These 3 parts can be combined in different ways. For example, a 70% first mortgage, 10% home equity second mortgage and 20% down payment. Talk with a Bank of America mortgage loan officer for information about combination loans.
Have more questions about adjustable-rate mortgages?
Talk with a Bank of America mortgage loan officer, who can help you decide if a hybrid adjustable-rate mortgage could be a loan option you should consider.