What is Adjustable Rate Mortgage?

What is Adjustable Rate Mortgage?

Adjustable rate mortgage loans are loans that are regulated by the federal government using the Cost of Funds Index (COFI). The COFI is a measurement of the interest a lender is required to pay against the money they have borrowed from the credit market. The lender takes the index rate and adds a profit margin to determine interest rates. If the rate index increases, the bank or lender will increase ARM rates to compensate.

As required by law, adjustable rate mortgage loans all have a lifetime rate cap that cannot be exceeded. What that means is that for the duration of the loan the interest rate increases cannot combine to be more than the lifetime cap. ARM loans also have adjustable period increase caps, meaning that the increase cannot exceed the agreed upon percentage from one period to the next.

Adjustable rate loans are more appealing to borrowers because they have very low initial interest rates. The low interest rates at the beginning of the loan term are often referred to as the “teaser period.” Usually these rates are below the index and the monthly payments will increase quickly once this period has ended. The risk of the COFI rate increase falls more to the borrower than to the lender, which is different than the risks with a fixed rate loan.

The adjustment period is decided on at the time the loan is drafted, so that if you agree to a 3-year ARM then the interest rate can only change once every 3 years. It is important to note that even  if the index rate moves down, the bank does not have to adjust the ARM downward. Some banks specify in the terms of the loan that it cannot be adjusted downward.

When deciding whether an ARM loan is right for you, ask yourself these questions:

  • Can I afford higher payments?

Know exactly how much you can pay each month and consider whether or not you could afford an increase in payments.

  • Will I need substantial loans in the future?

If you are planning to accrue future debts (car loan, student loan, etc.), having an ARM may decrease a lender’s willingness to grant you another loan.

  • How long will I live here?

If you are planning on leaving the property before the adjustment period is over, then any increase in the index rate will not matter. The longer you plan to stay in the property, the more likely it will be to have significant payment increases.

  • Do I want the option to pay off the loan early?

ARM lenders usually assess a penalty if the borrower wants to pay off the loan early. So if you want to pay off the loan a year early to avoid a potential rate increase the following year, you will have to pay a fee to your lender.

Adjustable rate mortgage loans are by definition highly variable. Depending on the COFI, the interest rate you will be paying with an ARM loan could be increased over time. When deciding whether you want to apply for an ARM loan in the Seattle area, pay attention to what’s happening in Seattle real estate trends and the current Seattle interest rates so you can make an informed decision.