(Mortgage)
What distinguishes a fixed-rate mortgage (FRM) from an adjustable-rate mortgage (ARM) loan?
A fixed rate mortgage differs from an adjustable rate mortgage in that the interest rate is predetermined at the time the loan is approved and will not change. The interest rate on an adjustable rate mortgage could increase or decrease.
Many ARMs will have lower interest rates at the beginning than fixed rate mortgages. For a few years, a year, or several years, this initial rate might not change. Your interest rate will change and your payment amount might increase once this introductory period is over.
Your interest rate will be partially based on an index, which is a more comprehensive way to measure interest rates. If the index of interest rates rises, your payment will too. Your payment may occasionally decrease when interest rates drop, but not for all ARMs. Some ARMs place a ceiling on how high your interest rate can go. Additionally, some ARMs have a cap on how low your interest rate can go.
Like all loans, they must fit the investment strategy or they run the risk of placing the borrower in an unfavorable position and resulting in them losing money. Interest-only loans and ARM options on long-term loans have been around for a while, but does everyone understand them?
Not all loan applicants are able to comprehend the bigger picture of these extremely specific loans and why they should take them into consideration. Here, we'll go over the advantages and disadvantages of these two loan types so you can see when and where each makes the most sense.
Let's define interest-only loans and ARM options first. An interest-only loan is exactly what it sounds like: monthly payments are made only for the interest, not the principal. If the borrower chooses an ARM option for a long-term loan, the rate will initially be fixed for a predetermined period of time, after which it will change. Consider a 7/1 ARM as an illustration: the borrower will have a fixed rate for seven years (7/1 ARM), after which the rate will adjust once (7/1 ARM) before the remaining loan term is finished.
Interest-only credit.
Pros:.
The monthly payments are smaller than they would be if the loan had a fully amortized schedule because they are made exclusively toward interest. Instead of worrying about making larger payments, borrowers can concentrate on stabilizing their financial situation. Potential candidates for interest-only loan consideration include borrowers with erratic income, poor financial standing, or those who do not intend to own the property for an extended period of time.
Cons:.
Even if a borrower meets the requirements for an interest-only option, they must carefully plan how they will handle this loan option and get ready for higher payments in the future. When the interest-only period ends, interest rates may still be low, but they may rise, forcing the borrower to pay not only higher interest but also principal at that point. Additionally, if a borrower only makes interest payments each month, they are not able to increase the value of their home.
ARM options for a long-term loan.
Pros:.
Compared to a typical, fixed-rate long-term loan, the ARM option will have a lower rate and lower payments in the beginning of the term. The ARM option allows borrowers to benefit from market rate declines without having to refinance their loan. If a borrower intends to keep the property for a brief period of time, this option might also be a more economical way to own investment real estate.
Cons:.
Early payments are lower, but as the loan term goes on, the payments can increase significantly. Not just because the fixed-rate period will end, but also because market circumstances could cause the interest rate to trend upward. For less experienced investors, understanding ARM options may also be more challenging. As a result, the benefits may not be readily apparent, preventing the investor from seeing potential advantages for their investment strategy.
You can see that depending on their use, each choice has advantages and disadvantages. Potential borrowers should be aware of what happens after they are granted one of these loans and are left to handle the loan payments. Remind yourself that loan terms expire and that if the borrower is not prepared, the loan payment may become impossible to manage in the future.
Consider all of your options, carry out your due diligence, and always speak with a loan officer to go over the current and future aspects of the loan. If you have any inquiries or would like a quote for a deal scenario that best suits your investment philosophy, get in touch with RCN Capital.
Financial products with a high degree of risk include interest-only adjustable rate mortgages. Borrowers take on the risk of rising interest rates as well as the prospect of a ballooning payment once the interest-only period expires. Additionally, because the mortgage principal balance is not decreased during the interest-only period, the rate at which home equity grows or shrinks is entirely reliant on home-price appreciation. Although most borrowers want to refinance an interest-only ARM before the interest-only period expires, a decline in home equity can make this challenging.
A lot of criticism was leveled at interest-only adjustable rate mortgages, or ARMs, in the years that followed the burst of the real estate bubble in the early 2000s. Such mortgages were advertised as a way for prospective homeowners to purchase homes they couldn't afford because they can be tantalizingly cheap to service during the interest-only period.
In the early years of the 2000s, when real estate prices were rising so quickly, mortgage lenders persuaded many homebuyers that they could purchase a pricey home using an interest-only ARM because continued price growth would allow those borrowers to refinance their loan before the interest-only period ends.
ARMs that are hybrid.
An initial five-year period of fixed interest rates is the first part of a 5/1 hybrid adjustable-rate mortgage (5/1 ARM), after which the rate adjusts annually. The "5" in the term denotes the number of years with a fixed rate, and the "1" denotes the frequency of rate adjustments after that (once a year). As a result, after five years, monthly payments may increase, sometimes significantly.
Additionally, there are ARMs that are 3/1, 7/1, and 10/1. These loans have an introductory fixed rate that lasts for three, seven, or ten years, respectively, after which they adjust yearly. Other ARM structures exist, such as the 5/5 and 5/6 ARMs, which both have a five-year introductory period followed by a rate adjustment every five or every six months, respectively. Notably, 15/15 ARMs only undergo one adjustment after 15 years and then stay fixed for the duration of the loan. 2/28 and 3/27 ARMs are less frequent.
Example of an interest-only ARM.
Let's say you take out a $100,000 interest-only, adjustable-rate mortgage at 5%, with a 10-year period during which only the interest rate is paid, and 20 additional years during which both the interest and the principle are paid. You would only have to pay $417 per month in interest for the first ten years, assuming that interest rates stay at 5%. The amount due each month would double when the interest-only period ends because you would then have to start paying principal as well as interest.
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