Adjustable Rate Mortgages (ARM)
WHAT IS AN ADJUSTABLE RATE MORTGAGE?
An Adjustable rate mortgage or ARM is a loan with a variable interest rate that can change periodically over the course of the loan term. Adjustable Rate Mortgages generally have an initial fixed rate period followed by and adjustable rate period. The fixed rate period can range from as short as 1 month to as long as 10 years. The most common adjustable rate mortgages are 3/1, 5/1, 7/1 and 10/1 ARMs. The initial 3, 5, 7 or 10 indicate the number of years the initial interest rate is fixed while the second number indicates the loan will adjust annually after the fixed rate period is over. These ARM programs are often referred to as Hybrid ARMs due to the initial fixed rate period.
ADVANTAGES OF AN ADJUSTABLE RATE MORTGAGE
The main benefit of an Adjustable Rate Mortgage is the initial rate will generally be lower than you can get on a fixed rate with the same length of loan term. The shorter the initial fixed rate period generally the lower the rate. How much lower the Adjustable Rate Mortgage is compared to a Fixed Rate Mortgage has a lot to do with the spread of long-term and short-term interest rates in the bond market, or steepness of the yield curve. An Adjustable Rate Mortgage is ideal for someone who either plans on paying off their mortgage within a relatively short period of time or someone doesn’t plan on staying in the current home for an extended period of time.
RISKS OF AN ADJUSTABLE RATE MORTGAGE
With the benefit of generally lower rate comes risk. If a borrower ends up keeping the loan longer than the fixed rate period the loan will adjust. Depending on short-term interest rates at the time of the adjustment a borrower could be looking at a significantly higher rate than they were previously paying.
All adjustable-rate mortgage programs come with a pre-set margin that does not change, and are tied to a major mortgage index such as the Libor, COFI, or MTA. Some banks and mortgage lenders will allow you to choose an index, while many rely on just one of the major indices for the majority of their loan products.
HOW DOES AN ADJUSTABLE RATE MORTGAGE WORK?
Below is a sample scenario of a 7/1 ARM
Initial rate: 3.75% – Fixed for the first 7 years of the loan
Index: 2.00 (can change) Most ARM’s use the 1 Year LIBOR Index
Margin: 2.25 (fixed and never changes)
Rate Caps: 5/2/5
Generally, an adjustable-rate mortgage will offer an initial rate for a certain period of time, whether it’s the first year, three years, five years, or longer. After that initial period ends, the ARM will adjust to its fully-indexed rate, which is the margin plus index. You can look up your current index rate quickly with a web search. The margin will be specified in your Loan Estimate or Closing Disclosure (Formerly the GFE and TIL).
Based on the sample scenario, your fully-indexed rate would be 4.25%. While the sample uses the most common margin, index and rate caps it is important for a consumer to know the details of their adjustable rate mortgage.
Margins can vary from lender to lender as can the caps and index.
Adjustable Rate Mortgage Interest Rate Caps
An Adjustable Rate Mortgage will have rate caps which limit the amount your rate can go up or down once the adjustable rate period of the loan is triggered.
Initial: How much the rate can increase or decrease after the initial fixed rate period. In the sample scenario, it would allow for a maximum adjustment of 5% higher than the start rate after 7 years if the index and margin at that time warrant such an increase.
Periodic: The periodic rate cap in the sample of 2%, is the maximum allowable increase or decrease in rate each year after the first adjustment. In the sample this would be in year 8.
Lifetime: The amount the rate can change during the life of loan. In the sample the rate could never exceed 8.75% regardless of how high the index increased at any time during the 30 year loan term.
Typically caps for conventional loans are 2/2/6 or 5/2/5. Generally the shorter initial fixed rate loans use a 2/2/6 and the longer initial fixed rate loans use a 5/2/5. Keep in mind the interest rate can increase or decrease. If short term rates are low, your adjustable rate mortgage could possibly drop!
Types of Adjustable Rate Mortgages
There are many different types of adjustable rate mortgages, with the initial fixed rate period ranging from one-month to 10 years. Obviously this represents quite a range of risk, so be careful when comparing different loan products. Below are the most common ARM’s currently being available.
1-month ARM: First adjustment after one month, then adjusts monthly
6-month ARM: First adjustment after six months, then adjusts every six months
1-year ARM: First adjustment after one year, then adjusts annually
3/1 ARM: First adjustment after three years, then adjusts annually
5/1 ARM: First adjustment after five years, then adjusts annually
7/1 ARM: First adjustment after seven years, then adjusts annually
10/1 ARM: First adjustment after 10 years, then adjusts annually
As you can see, an ARM can give you as long as 10 years of fixed-rate payments, or as little as one month.
Why Choose an Adjustable-Rate Mortgage?
Ideally a borrower will choose an adjustable-rate mortgage when their intent is to sell the property prior to the first rate adjustment. Some homeowners get into adjustable-rate mortgages with the assumption that they can refinance the loan when the fixed period ends. While this is often true, there is risk that rates in the future may be higher. Qualification can also become an issue due to an unforeseen financial hardship or decrease in home values. It is important you understand the risks and rewards of an Adjustable Rate Mortgage prior to making your decision.