Adjustable rate mortgages (ARMs) are home loans with a variable interest rate. Some homeowners or potential homeowners, with record-low interest rates from few years ago creeping upward, are now considering an ARM for the first time. The hope is to take advantage of current interest rates, which are still historically low, but potentially capture future drops in interest rates.
So how can you decide if an ARM is right for you? First, learn about the different factors which affect the ARM and then consider how these factors fit with your lifestyle and goals. Here are the basics that you need to know before doing further investigation into ARMs:
The index rate is the base rate upon which the lender will add a fixed percentage (margin), and is the rate that will vary. This rate is typically based on one-, three-, or five-year U.S. Treasury security rates, the rates set by the Federal Reserve Bank, or the Fed. The index can also be based on the Cost of Funds Index (COFI) used by savings and loan associations, or the London Interbank Offered Rate (LIBOR).
As mentioned, the margin on an ARM is the number of percentage points the lender will add to the index when payments are adjusted. The lender will base this figure on a number of factors, including your credit worthiness, how much you are putting down, and the term or duration of the loan.
An ARM usually has an adjustment period, which is the length of time before the rate is scheduled to reset with its index. If the index doesn’t change, the rate won’t change unless other terms are applicable. The typical initial length can range anywhere from two to seven years, and usually in one-year increments thereafter. Be sure to discuss the details of the adjustment period with your lender.
Most ARMs are designated by two numbers, divided by a slash, but it isn’t a ratio. The first number is the number of years of the adjustment period, and the second refers to how often the rate will be adjusted, so a 5/1 ARM (also known as a hybrid ARM, but most are these days) has an adjustment period of five years and the rate would be adjusted every year after the initial period.
Interest Rate Caps
Interest rate caps are usually part of the adjustable rate mortgage terms. These caps are also designated with a set of numbers divided by slashes. A common interest rate cap is 2/2/6, which means the adjustment is limited to 2 percent in the first adjustment, 2 percent in the adjustments that follow, and up to 6 percent as the lifetime cap. The lifetime cap is the total of all of the increases over the life of the loan.
A complicated-sounding term, negative amortization simply means the payments are too low to cover the interest and the mortgage balance is increasing. This is another important factor to discuss with your lender.
Early payment and other factors
In some cases, banks may impose penalties or other fees for early payment of the ARM loan.
Hang onto your hats — “payment shock” is the term for the reaction to the first installment payment at a new rate. Be sure to discuss potential payment changes with your lender and understand how often your ARM loan payment may change over the term of the loan to avoid, or at least reduce, the shock.
Is an ARM right for you?
With rates only slightly lower than in recent years, it might be unlikely that rates will again drop or stay as low over the 15- or 30-year term of the loan. The annual average for 2013 was 3.98, but 30 years ago, in 1983, the annual average rate was 13.24. Clearly, an ARM mortgage holder 30 years ago would have fared well (or refinanced along the way), but if rates climb back to those levels, today’s ARM borrowers might not be happy down the road without selling or refinancing.
An adjustable rate mortgage may be a good option for anyone planning to move in a few years and can afford payments on a short-term mortgage, although risks to owning for the short term include negative equity, or being underwater on the mortgage. For a 30-year mortgagee, an ARM may be more risky, as the equity in the home will be lower in the short term.
For more information on the best mortgage rates, visit our mortgage page.