The two most popular loan types for buying a home in the Nashville area are fixed-rate and adjustable-rate mortgages. Both options are available for conventional conforming loan amounts and jumbo (non-conforming) loan amounts as well as FHA or VA programs.
Adjustable-rate mortgages (ARMs) have monthly payments that can move up and down as interest rates fluctuate. Most have an initial fixed-rate period where the rate doesn't change for the borrower, followed by a longer period where the rate changes at pre-set intervals.
Generally, one of the main advantages of an adjustable rate mortgage is that the initial interest rate is lower than that of a fixed rate mortgage. A lower rate means lower monthly payments, which may help you qualify for a larger loan. This is an important detail if you expect your future earnings to rise. Choosing an ARM would allow you to qualify for a larger loan amount earlier rather than later.
Keep in mind that after the fixed-rate period ends with an ARM, the interest rate can rise, so your monthly payments will go up as well. And since interest rates are fairly unpredictable, you really can't predict what your payments will be in the future.
Also, if you use an ARM to qualify for a larger loan amount than a fixed rate would allow you, and the interest rate rises drastically - or your income doesn’t increase as planned - you may not be able to afford the increase in your monthly payments, which could result in defaulting on your loan.
If you are considering buying a home in the Nashville area, but only planning on owning it for a few years, the risk of the interest rate rising goes down. This means that you will get a better rate with an ARM - making it a good choice. However, if you plan on staying in your home for a longer period, a fixed rate mortgage is probably the better option for you.
The most popular adjustable-rate mortgage is the 5/1 ARM - the introductory rate lasts 5 years.
After that, the interest rate can move up and down with another interest rate called the index.
The index is an interest rate set by the market. There are many indexes, and depending on your loan, your ARM will follow a specific index.
The ARMs Rate
Your lender will take the index rate and add an agreed-upon number of percentage points - called the margin - in order to set the ARM rate. The index rate can change, but the margin doesn't change. As an example: The index is 1.25% and the margin is 3 percentage points. When added together, you have an interest rate of 4.25%. If the index is 1.5 % a year later, then the interest rate will rise to 4.5 %.
Caps on ARMs
As a borrower, you are insulated from huge year-to-year increases in monthly payments because ARMs come with "caps," which limit the amount that rates and payments can change.
A periodic rate cap limits how much the interest rate can change from one year to the next; A lifetime rate cap limits how much the interest rate can rise over the life of the loan; And a payment cap limits the amount the monthly payment can rise over the life of the loan in dollars - rather than percentage points.
The ARMs Takeaway
If you are planning on buying a home in the Nashville area and considering an adustable-rate mortgage loan to pay for it, make sure you have clear goals and a plan for all evenualities, including "worst case scenario."
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