Adjustable-Rate Mortgages and the Buydown Option

Interest rates compose a significant portion of your monthly mortgage payment. They are constantly changing, but when they are consistently moving upward during your home search, you will need to consider ways to lock an interest rate you can afford for possibly the next 30 years. Two options for borrowers are adjustable-rate mortgages (ARMs) and mortgage buydowns to reduce the interest rate. Let's look at ARMs first.

What is an ARM?

With an ARM, your rate will likely start lower than that of a fixed-rate mortgageA home loan with an interest rate that will not change over the life of the loan.fixed-rate mortgageA home loan with an interest rate that will not change over the life of the loan. for a preset number of years. After the initial rate period expires, the rate will either go up or down based on the Secured Overnight Financing Rate (SOFR) index.

While the unpredictable nature of ARMs may seem risky, it can be a great option for homebuyers who are seeking shorter-term housing (military, etc.), are comfortable with the risk, and would rather pay less money upfront. Here’s how ARMs work.

The Initial Rate Period

The initial rate period is perhaps the biggest upside to applying for an ARM. Every loan’s initial rate will vary, but it can last for as much as 7 or 10 years. This starting rate’s time period is the first number you see. In a 7/1 ARM, the “7” means seven years.

The Adjustment Period

This is the time when an ARM’s interest rate can change, and borrowers could be faced with higher monthly payments. With most ARMs, the interest rate will likely adjust, but it’s up to your lender and the security of the investment bond your loan is tied to whether it’ll be higher or lower than your percentage during the initial rate period. It’s the second number you see and means “months.” For a 7/1 ARM, the “1” means the rate will adjust every year after the seven-year fixed period.

The Index

The index is an interest rate that reflects general market conditions. It is used to establish ARM rates and can go up or down, depending on the SOFR it’s tied to. When the fixed period is over, the index is added to the margin.

The Margin

This is the number of percentage points of interest a lender adds to the index to determine the total interest rate on your ARM. It is a fixed amount that does not change over the life of the loan. By adding the margin to the index rate, you’ll get the fully indexed rate that determines the amount of interest paid on an ARM.

Initial Rate Caps and Floors

When choosing an ARM, you should also consider the interest rate caps, which limit the total amount that your rate can possibly increase or decrease. There are three kinds of caps: an initial cap, a period-adjustment cap, and a lifetime cap.

An initial cap limits how much the interest rate can increase the first time it adjusts after the initial rate period expires. A period-adjustment cap puts a ceiling on how much your rate can adjust from one period to the next following your initial cap. Lastly, a lifetime cap limits the total amount an interest rate can increase or decrease throughout the total life of the loan. If you’re considering an ARM, ask your lender to calculate the largest monthly payment you could ever have to make and see if you’re comfortable with that amount.

The three caps come together to create what’s known as a “cap structure.” Let’s say a 7/1 ARM, meaning the loan has a fixed rate for the first seven years and a variable interest rate that resets every following year, has a 5/2/5 cap structure. That means your rate can increase or decrease by 5% after the initial period ends, rise or fall by up to 2% with every adjustment thereafter, and can’t increase or decrease by more than 5% past the initial rate at any point in the loan’s lifetime. Not every loan follows the 5/2/5 cap structure, so substitute your numbers to see how your rate will, or won’t, change until it’s paid in full.

At this point, you’re probably more concerned with an interest rate’s caps, but one other thing to consider is your rate can potentially decrease after the initial rate period ends. Some ARMs have a “floor” rate, or the smallest percentage it can ever possibly reach. Even if the index says rates should decrease, yours might not decline at all if you’ve already hit your floor.

Who Should Apply for an ARM?

Like most things in life, there are pros and cons to every situation – and the type of mortgage you choose is no different. When it comes to ARMs, there are certainly benefits to choosing the “riskier” route.

Since an ARM’s initial rate is often lower than that of a fixed-rate mortgage, you can benefit from lower monthly payments for the first few years. And if you’re planning to stay in your new home shorter than the length of your initial rate period allows, an ARM is a phenomenal way to save money for your next home purchase.

But ARMs aren’t the only way you can save on your interest rate. Mortgage buydowns are another excellent option available to all borrowers.

What is a Mortgage Buydown?

Mortgage buydowns are a way to reduce interest rates at the closing table. Borrowers can pay for mortgage points, or discount points, as a one-time fee alongside the other upfront costs of purchasing a home. Each mortgage point is based off a percentage of the total loan amount. Purchasing points gives you the opportunity to “buy down” your rate by prepaying for some of your interest. This transaction will take a percentage off your quoted interest rate – giving you a lower monthly payment.

Mortgage points vary from lender to lender, just like interest rates, but each point typically represents 1% of the total loan amount. One point will typically reduce your interest rate by 25 basis points or 0.25%. So, if your loan amount is $200,000 and your interest rate was quoted at 6%, one discount point may cost you $2,000 and reduce your rate to 5.75%.

Expert Tip

Some buydown rates can expire, so be wary of rate increases down the line.

In some cases, sellers or builders may offer buydowns, but most transactions occur between the lender and the borrower. In many cases, the buydown method will help you save more money in the long run.

Unlike ARMs, a mortgage buydown is best for those who want to stay in their homes for the foreseeable future. That’s why it’s important to always keep your end goal in mind when purchasing a home. Always ask yourself if this loan is a short-term or long-term solution to your homeownership goals.