An adjustable rate mortgage (ARM) is a mortgage that does not have a fixed interest rate that remains the same over the loan’s duration. Instead the interest rate fluctuates due to a predetermined trigger or follows a particular external interest rate. This means, of course, that your monthly mortgage payment will change periodically.
One reason ARMs are attractive is because they generally begin with a lower interest rate than the current fixed rate loans. If you expect to earn more money over time or you don’t expect to stay long in the home, and ARM could be the mortgage for you.
Terminology
ARMs are structured using these components:
- Index: This is the guide for the interest rate and there are several that can be used by lenders.
- Activity of one, three, and five year treasury securities
- Constant Maturity Treasury (CMT)
- One year London Interbank Offered Rate (LIBOR)
- 11th District Cost of Funds Index (COFI)
- Margin: This is like a retail mark-up. This is the amount added to the base interest rate to cover the lender’s costs and provide them with a profit. The margin typically stays the same over the life of the loan. Your payment will be the index plus the margin. Margins differ between lenders so shopping around can often get you a lower one.
- Interest Rate Cap Structure: This is the part of the loan that keeps the interest rate from skyrocketing and your mortgage payment along with it.
- Periodic caps keep interest rates steady from one adjustment period to the next. These are not available on all ARMs.
- Overall caps (Lifetime Caps) limit the interest rate increase over the loan’s duration. These have been mandated by law for every ARM since 1997.
- Payment caps are available for some ARMs. This limits how much the monthly payments can go up over the loan duration rather than limiting the rate change by percentage points.
- Adjustment period: this is the amount of time between possible interest rate increases or decreases. You can tell how often the interest rate may fluctuate by a term within the loan agreement, usually stated as something like 1-1, 3-1, 5-1. The first number indicates the initial loan period where the interest rate will stay the same. The second number is the adjustment period, which is how often adjustments are allowed after the initial loan period. These examples show ARMs that have 1, 2, and 3 year initial loan period after which adjustments may be made annually. Adjustment periods can range from 1 month to 10 years.
Pros and Cons of ARMs
The biggest pro of ARMs was mentioned earlier: they have lower initial rates than fixed rate mortgages. If your loan will not last long because you intend to sell the home within a short time (a few years) this is a way to save money on mortgage payments will still being able to own a home. Maybe you expect your salary to increase over the same time period as the interest rate. This can mean payments as a percentage of your earnings won’t change.
However, the fact that payments can go up after a certain time period may add a note of uncertainty to your budget that you don’t feel comfortable with. With the lifetime cap requirement you can be assured the rate will only go up a certain percentage but be prepared in case the first adjustment takes the payments to the limit.
Know also that in the event that an interest rate cap kept your monthly payment the same through an index increase that there is a possibility the amount of that index increase could be “carried over” to the next adjustment period and making it a double hit.
Be Savvy, Be Prepared
Before taking out an adjustable rate mortgage, ask questions of the lender so you are clear on the particulars of your specific loan agreement. Lenders are required to give you the information in writing for comparison purposes.
Do your research and find out the interest rates of the major indexes before contacting a lender. The lender can tell you which index the mortgage you are considering is tied to.
Find out, also, whether the ARM you are considering is assumable or can be converted at a later time to a fixed rate loan. For the latter, ask about the fees involved so you don’t lose all the savings from the previous lower payments.
Education and research are your best friends when taking on a home mortgage. Adjustable rate mortgages come with another layer of complexity but can be the right thing for you if you do your homework.
