How Amortization Works on Adjustable-Rate Mortgage
When used as a verb, ‘amortize’ means to set up a payment schedule. So when a lender amortizes a loan, that just means they set up a schedule that pays them interest owed and pays down principal, usually calculated to pay off the loan amount in a certain number of months. On a standard fixed-rate mortgage, the loan is amortized (payment schedule is set up) once at the very beginning of the loan, and that schedule is maintained until the loan is paid off. If you make more than the minimum payments, you are considered “ahead of schedule”, your loan will be paid off sooner, and you’ll save a fair amount of money in interest. There’s a lot of advantage to being ahead of schedule on a fixed rate loan, but making more than the minimum payment is even better when you’re on an adjustable-rate mortgage.
Its Greatest Weakness is Also Its Greatest Strength
Adjustable-rate Mortgages (ARMs) are often criticized for being unpredictable, volatile, and always giving you a higher rate than you were promised. In the interest of being transparent, most of this criticism does not apply to the VA hybrid ARM, which has specific protections built-in to prevent those things from happening. However, those weaknesses are mostly the result of the interest rate adjusting. Since what differentiates an ARM from a fixed-rate is the interest rate adjustment, the potential for an ARM loan to have a higher interest rate is definitely there, and can be considered a weakness of the ARM. However, in order to adjust the interest rate, an ARM loan has to reamortize. What does it mean to reamortize? It means to make a new schedule during which the loan must be paid off. Most hybrid ARM loans have a loan term of 30 years. When the loan is initially amortized at the beginning of the loan, it stays the same throughout the initial fixed period, then once the interest rate starts adjusting annually, the loan reamortizes. What does reamortizing do? Well, if you’ve been making more than the minimum payment (especially while your interest rate is in the very low fixed period), reamortization lowers your monthly payment because it takes the amount of principal you still owe and spreads it over the remaining life of the loan to calculate a new minimum payment. This means you can pay off even more principal if you continue to pay more than the minimum. There have been many cases where a borrower’s interest rate has gone up, but their monthly payment has still gone down because of reamortization.
Comparing ARM vs. Fixed
Paying extra on a fixed-rate mortgage saves you money and helps you pay off your loan faster, but it does not affect your minimum monthly payment, which means you are more limited in your ability to make faster-than-scheduled progress on your fixed-rate loan. Reamortization on an ARM loan gives you a very distinct advantage in this area; you get credit for the extra principal you’ve paid off, and the loan holder re-schedules the payments to the minimum required to hit the original loan payoff date. If you continue to make more than the minimum payment, the effect compounds, until you’re only required to make a very small payment and you’re paying off way more principal than you’d be able to on a fixed-rate mortgage. If you’re looking for a reason to check out the VA hybrid ARM, this is a really good one. When you combine the effect of reamortization with the much lower starting rates, plus a non-volatile index that the interest rate is based on, the VA hybrid ARM starts to show a great deal of advantages and very few disadvantages. Access to the VA hybrid ARM is one of the greatest benefits to the VA loan program.
So, amortization means setting up a schedule to pay back a loan, usually with the goal of paying it off by a certain date. A fixed-rate loan amortizes just once at the beginning of the loan and stays the same regardless of how much ahead of schedule you are. If you pay it off early, it’s over and done with. An adjustable-rate mortgage amortizes once at the beginning, once at the end of the fixed period, then once annually when the interest rate changes. This reamortization allows the lender to give the borrower credit for the extra payments they’ve made and make a new schedule for the borrower to pay off the remaining balance on the loan. This means the borrower has the same amount of time to pay off less money, which results in a lower monthly payment, which can often offset or even outweigh an increase in the interest rate.