These limits will determine how much your rate is adjusted every five years. In addition to the different types and terms of loans, you'll need to decide if you want a fixed-rate loan or an adjustable-rate mortgage (ARM) loan. An ARM has a fixed rate for the first few years of the loan term, which is often referred to as the initial rate because it's lower than any comparable rate you can get for a fixed-rate mortgage. For 5 years, homebuyers who choose an ARM enjoy fixed payments, generally at a lower interest rate than buyers with a fixed-rate mortgage.
Also known as a five-year fixed-period ARM or five-year ARM, this mortgage has an interest rate that is adjusted according to an index plus a margin. An ARM also has limits that limit the amount that an interest rate can change after the initial fixed period has expired, as well as a minimum limit that limits the lowest rate that can be reached after the initial fixed period. One strategy that some people use is to take the difference between what they would have paid for a fixed-rate mortgage and their ARM and apply it to the equity of the mortgage, so that the mortgage is paid off more quickly and tens of thousands are saved in interest. People like them because they're generally less expensive (they have a lower interest rate) than a traditional fixed-rate mortgage, and in fact, ARMs may be a better option in certain situations (see below).
Some ARM loans come with a conversion option, allowing you to switch your ARM to a fixed-rate mortgage sometime in the future. In most cases, ARMs offer lower introductory rates than traditional mortgages with fixed interest rates.
Hybrid mortgagesare very popular with consumers because they can have a significantly lower initial interest rate than a traditional fixed-rate mortgage. To understand the differences between adjustable-rate and fixed-rate mortgages, it is useful to analyze the advantages and disadvantages of ARMs.
When refinancing an ARM mortgage to a fixed-rate mortgage, it's important to carefully consider the new loan term, as it could have a significant impact on the amount you pay in total interest for owning the home. Only after the introductory period ends, ARMs can become more expensive and unpredictable, depending on what happens to interest rates in the macroeconomic environment. You should assume that your loan will be adjusted to a higher interest rate, possibly up to the limits included in your loan over time. So, let's say that the following year the 1st UST rose by 9%, the fully indexed rate will not be 11.75% (margin of 2.75% + 9% UST), but the fully indexed rate will return to 8.5%, since the 2% limit limited the change.
If you're saving a significant amount on the initial part of the loan by opting for an ARM, it may be worth it.