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When Is An ARM Loan A Good Choice?

When is an ARM loan a good choice?

When you read about mortgage rates today, you see the good old, dependable 30 year fixed rate loan. When you read about adjustable rate mortgages, called ARMs, it is often in the context of how dangerous they are, and how they are the culprit for the financial crisis of 2008.

Recent history of ARM loans

There is some truth behind that bad reputation. There were mortgage products available in the years leading up to the crisis that were certainly toxic—like those whose payments could literally double in two years. Or those “Pick-A-Pay” mortgages with jaw-dropping low payments, but with balances that quickly ballooned to 120% of the original loan amount.

Good news about ARMs

Thankfully, those kinds of destructive loans no longer exist. There are other types of ARMs, however, that you may find suitable for your own situation. These are called “intermediate term ARMs,” or “hybrid ARMs.” These loans feature a rate that is fixed for an extended period of time—5, 7 or even 10 years—before converting to an ARM that adjusts annually, subject to certain limitations, or “caps.”

Here is how adjustable rate mortgages work: first, there is a number called a “margin.” The margin is constant over the term of the loan. Next, there is an “index.” This is a publicly available number that changes regularly. The LIBOR index (London Inter Bank Offered Rate) is common, as is the 12 month U.S. Treasury rate. When the time comes to begin adjusting the interest rate, the lender adds the margin to the value of the index at the time to arrive at the rate for the next year. A mortgage based on the LIBOR rate, for example, would adjust today to 3.55%—margin of 2.25 plus today’s LIBOR of 1.30%.

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There are limitations, called “caps,” imposed on the loan’s annual adjustments. There is a cap for the first adjustment after the fixed period, one for the annual adjustments after the first one and a “life cap:” the maximum rate for the loan. Lenders typically express these caps in the form, 2/2/5. This means 2% maximum for the first adjustment after, say, 5 years, 2% maximum adjustment for each year thereafter, and 5% maximum increase over the life of the loan.

Here’s when an ARM loan is a good choice

Why would anyone in their right mind choose a complicated loan that might have a higher interest rate in the future? If you were certain that you were only going to have the loan for, say, 5 years because you planned to move, you’d save money with the lower rate of a 5-year ARM. You can count on a rate .375% lower for that kind of mortgage than for a 30-year fixed rate loan. That difference would give a payment $85.00 lower than for a $400,000, 30-year fixed rate loan.

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While that may seem to be a trifling amount, it would add up to more than $5,000 over a five-year span. Looking at it another way, if you were to opt for a 5 year, $400,000 ARM but made the payment for a 30-year fixed rate loan, you’d have $10,000 more equity at the end of the 5-year term. That would mean $10,000 more in your pocket when you sold the property.

Making your decision on an ARM loan

Is an intermediate ARM right for you? Should you even consider this type of mortgage? The answer will depend on two things: first, are you confident of your time frame—how likely is it that you will pay off that loan at the end of the initial fixed term? Second, are you comfortable with the fact that your loan will change at the end of the initial fixed period? Even though you may feel certain that you will sell this home in five years, if you feel as though you have a sword hanging over your head all that time could cause you to lose sleep. This is not a worthwhile trade-off.

Finally, keep in mind that the rates for hybrid ARMs can adjust downward as well as upward. Many homeowners got 5-year ARMs starting at 6% in 2010. Today, they are paying 3%. There are no guarantees about rates in the future, but it is important to keep in mind that ARMs do not always increase.

arm loan rates

It can be extremely difficult to make a decision on an ARM loan on your own. To speak with a mortgage professional about your options, you can contact us now. Or, if you’re simply seeking more information on the process of buying a new home, click the button below to download our new ebook.

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