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How Does an Adjustable Rate Mortgage Work?

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What are adjustable rate mortgages? 

An adjustable rate mortgage, also known as an “ARM,” “variable rate mortgage” or “floating mortgage,” is a loan that finances your home at a variable interest rate. A variable interest rate is an interest rate that adjusts over time based on the underlying prime rate and rates set by the Federal Reserve. For example, if the federal funds rate goes up, your monthly mortgage payments will increase. If mortgage interest rates go down, your monthly mortgage payments will decrease. See how that works? 

ARMs are typically 30 year mortgage loans with two different periods: 

Fixed period: This is the initial stage of the loan where your interest rate is “fixed’ and won’t change for the first 5, 7 or 10 years, depending on the terms of your ARM. 

Adjustment period: This is the remaining period when your interest rate will adjust, going up or down based on the benchmark rate that we discussed earlier. 

In addition to the term, you have the option to choose a conforming or non-conforming loan. 

So what’s the difference between conforming and non-conforming ARM loans?

The difference is simple: conforming loans meet specific guidelines that allow them to be sold to Fannie Mae or Freddie Mac. Just to give you some background information, Fannie Mae and Freddie Mac are two of the largest, government-backed mortgage buyers in the country. It’s fairly common for lenders to sell mortgages to these institutions as a way to issue loans for more prospective homebuyers.

Non-conforming loans do not meet the same guidelines and therefore harder to sell for repackaging on the secondary mortgage market. Due to this fact, non-conforming loans generally require a lower down payment and credit score, but are offered at higher interest rates due to their riskier nature. My best advice is to read the fine print if you choose this route! Not all non-conforming lenders will have your best interests at heart, so it’s critical to know the terms of rate resets before you sign the dotted line. 

The Bottom Line

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