Homeowners in California have several ways to convert their home equity into cash. One common…
Using an ARM Loan to Buy a Home in California: Is It Right for You?
Home buyers in California have a lot of different options when it comes to their mortgage financing. One of those choices has to do with the rate structure associated with the loan.
For instance, California home buyers can choose between an adjustable-rate mortgage (ARM) loan, or one that has a fixed rate over the life of the loan. There are pros and cons to all of these choices. So you’ll need to do some thorough research to identify the best financing option for your situation.
In this guide: We will explore the reasons why some home buyers in California use adjustable-rate mortgage loans when buying a house, so you can decide if it’s right for you.
Top 10 Things to Know About ARM Loans
We’re going to take a deep dive into the world of adjustable-rate mortgage loans, to help you understand how they work. But first, let’s start with some basic concepts.
Here are ten things California home buyers should know about ARM loans:
- ARM loans have an adjustable interest rate that can change over time.
- They can also have an initial “fixed” stage where the rate stays the same.
- In most cases, the interest rate will adjust once per year following the fixed phase.
- These adjustments could result in higher monthly mortgage payments.
- ARM loans typically have lower rates than fixed-rate mortgages (at least initially).
- Many people who use ARMs either sell or refinance before the first adjustment.
- Caps and limits protect borrowers against extreme interest rate fluctuations.
- Consider your future income potential and financial stability before choosing one.
- Have a contingency plan and financial reserves to manage payment fluctuations.
- Evaluate your risk tolerance and ability to handle potential payment increases.
Next, we’ll explore the basic features of an ARM loan and when it might make sense to use one.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage (ARM) loan is a type of mortgage loan where the interest rate can change periodically over the life of the loan. This is different from a fixed-rate mortgage, where the interest rate remains the same for the entire life of the loan.
Worth knowing: The 30-year fixed mortgage is the most popular type of loan among home buyers in California. ARM loans are less common but can be useful in certain scenarios.
ARMs are typically structured as follows:
- Initial fixed-rate period: The loan begins with a fixed interest rate for a set period, typically 3, 5, 7, or 10 years.
- Adjustment period: After the initial fixed-rate period, the interest rate adjusts periodically, usually once a year, based on a benchmark index like the one-year Treasury bill rate.
- Margin: The margin is a percentage the lender adds to the index rate to determine the new interest rate, after the initial fixed phase has ended.
For example, let’s consider the 5/1 ARM loan. This type of mortgage loan has a fixed interest rate for the first five years. After that, the rate will adjust every one year (or annually).
Another example is the 7/6 ARM. This type of adjustable loan provides a fixed interest rate for the initial seven years. Following the seven-year fixed period, the interest rate will adjust every six months.
Key point: Borrowers with ARM loans typically receive advance notice from their loan servicers regarding upcoming rate changes. Even so, it’s hard to predict how the rate will behave over the long term.
Key Features of ARM Loans
If you’re thinking about using an adjustable-rate mortgage loan to buy a home in California, there are some important concepts you should understand.
Here are some of the most important features of ARM loans:
Initial fixed-rate period: Adjustable-rate mortgages typically start with an initial fixed-rate period, during which the interest rate remains constant. This period can range from a few months to several years, depending on the terms of the loan. It provides borrowers with stability during the first few months or years, before the adjustments begin.
Index and margin: The interest rate adjustment for ARMs is based on an index, such as LIBOR or the Treasury Bill rate. The margin is a predetermined percentage added to the index to calculate the new interest rate. Home buyers should know the specific index and margin used with their ARM, because they affect future interest rate adjustments.
Caps and limits: ARMs often include caps or limits to protect borrowers from drastic interest rate fluctuations. Periodic adjustment caps limit the amount the interest rate can change at each adjustment period. Lifetime caps impose a maximum limit on the interest rate increase over the life of the loan.
Adjustment frequency: This frequency determines how often the interest rate is recalculated and adjusted. This frequency can vary depending on the loan terms, with common periods being one year, three years, or five years. The adjustment frequency directly affects how frequently borrowers can expect changes in their mortgage payments.
When Does It Make Sense to Use One?
So now you know what an adjustable-rate mortgage is and how it can behave over the long term. But how do you know if it’s the right financing option for you?
Here are some financial scenarios where it might make sense for a home buyer in California to use an ARM loan:
1. If you plan to sell the home in a few years.
ARMs typically have lower starting interest rates than fixed-rate mortgages, so you could potentially save money on your monthly payments early on. And if you sell the home before the interest rate adjusts, you won’t have to worry about your payments going up.
2. If you have a strong and consistently reliable cash flow.
ARMs can be a good option for borrowers who can afford to make higher monthly payments if interest rates rise. If you have a stable income and expect it to continue to grow, you may be able to handle the risk of an adjustable-rate mortgage.
3. If you plan to refinance your mortgage in a few years.
If you’re planning to refinance your mortgage after a few years, an ARM could be a good way to save money on your monthly payments in the meantime. However, it’s important to note that interest rates could rise by then, making it more expensive to refinance.
4. If you’re buying a starter home.
ARMs can be a good option for first-time home buyers in California who are looking for a lower monthly payment. Just be sure to have a plan for handling potential interest rate increases and higher monthly payments.
What are your financial goals for the future? If you’re planning to stay in your home for a long time, a fixed-rate mortgage may be a better option. However, if you plan to sell the home in a few years or refinance your mortgage, an ARM could be a good way to save money during the first few years of homeownership.
The Importance of Exploring Your Options
You have a lot of different options when it comes to choosing a mortgage loan in California. And the fixed-versus-adjustable distinction only scratches the surface.
This underscores the importance of working with a knowledgeable mortgage professional — someone who will take the time to explain the pros and cons of different financing methods.
As a mortgage broker, we have access to multiple lenders with many different home loan options. This allows us to match each individual client with the most suitable type of mortgage loan based on their unique situation.
Maybe an ARM loan is a good idea. Or maybe you would be better off using a long-term fixed-rate mortgage. We can review your financial situation and goals to help you make the right choice.