Lower initial interest rate
An adjustable-rate mortgage (ARM) refinance typically provides a lower interest rate for an initial payment period, making the initial monthly payments less than those a fixed-rate mortgage refinance usually offers.
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.
Refinancing into an adjustable-rate mortgage could be a good way to lower your monthly payments in the short term, but there are other things to consider, including fluctuation of interest rates and monthly payments.
Things to consider
After the lower initial rate period, the ARM interest rate will adjust to a fully Glossary Term: indexed rate and could increase your rate and payments. If the rate goes up, your monthly payments go up, so you want to be financially prepared to make larger payments.
Adjustable-rate mortgage refinance loans are a good choice if you:
- Are planning to move in a few years (before the end of the initial rate period)
- 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 lower initial monthly payments than a fixed-rate mortgage usually offers
- Think interest rates may fall in the future
Some disadvantages of adjustable-rate refinance mortgages:
- If you plan to sell the home before the introductory period ends, there is an element of risk, as it can be difficult to predict exactly how long it will take to sell your home
- Interest rates will increase in a rising rate environment
- An increase in rates will increase your monthly payment amount, which may not keep pace with any increase in income
- An increase in interest rate will reduce accumulation of Glossary Term: equity, especially where home values are declining, and may make it more difficult to refinance your loan again
Types of hybrid ARMs
10/1 adjustable-rate mortgage refinance
A 10/1 ARM refinance has a fixed interest rate for the first 10 years. After 10 years, the rate can change once every year for the remaining term of the loan. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
7/1 adjustable-rate mortgage refinance
A 7/1 ARM refinance has a fixed interest rate for the first 7 years. After 7 years, the rate can change once every year for the remaining term of the loan. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
5/1 adjustable-rate mortgage refinance
A 5/1 ARM refinance has a fixed interest rate for the first 5 years. After 5 years, the rate can change once every year for the remaining term of the loan. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
ARM interest rate caps and indices
The rate you pay on an ARM after the initial rate is based on a fluctuating 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 loan terms.
ARM loans typically feature an Glossary Term: adjustment “cap,” which limits how much the interest rate can go up. However, many rate caps allow significant monthly payment increases that could result in “payment shock.” After the initial fixed-rate period, the monthly payment and interest rate for ARM loans adjusts once per year.
When finding out about ARM refinance options, be sure to ask the following questions:
- Does the ARM you’re considering include a rate cap?
- How often does the rate change?
- Is your ARM Glossary Term: assumable?
- Are there any penalties for paying off your loan early, also called a prepayment fee? Being able to prepay your ARM will allow you to refinance again if rates go down.
Every ARM 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 ARMs are based.Footnote 1
Even though rate indices may adjust more frequently than every year, Bank of America ARMs do not adjust more frequently than once a year.
Treasury-Indexed ARMs (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 from Bank of America will adjust once each year. Per-adjustment Glossary Term: caps and lifetime rate caps vary.
London Interbank Offered Rate ARMs (LIBOR)
The LIBOR index tracks the rate international banks charge each other for large loans in the London interbank market. This ARM 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. A higher interest rate plus an increase in the payment amount to include principal and interest could increase your monthly payments even more than with a fixed-rate interest-only 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.
If your mortgage will be for an amount higher than Glossary Term: conforming thresholds, a jumbo mortgage may be an option. Glossary Term: Jumbo loans are available for primary residences, second or vacation homes and investment properties and are also available in a variety of terms. Jumbo home loans typically have a higher interest rate than smaller home loans due to different Glossary Term: underwriting and home equity requirements.
A combination loan pairs a conforming first mortgage with a home equity second mortgage for up to 80% of the property’s value in a single application. Combination loans may help you avoid the higher rates of a jumbo first mortgage. Combination loans are made up of 3 parts:
- First mortgage
- Second mortgage (home equity loan or line of credit)
- Cash down payment or existing home equity
These 3 parts can be combined in different ways. For example, a 70% first mortgage, 10% home equity second mortgage and 20% cash payment or existing home equity. Talk with a Bank of America mortgage loan officer for information about refinancing and combination loans.
Have more questions about ARM refinance options?
Talk with a Bank of America mortgage loan officer, who can help you decide if an ARM could be right for you.