Adjustable-Rate Mortgages (ARM)

A first mortgage typically has a set interest rate. The monthly payment stays the same regardless of the term. It doesn’t matter how much the economy, the Federal Reserve or your income change. Your interest rate is locked in over the life of the loan.
An Adjustable-Rate Mortgage (ARM), on the other hand, has an interest rate that can change periodically. These loans usually have a period of time in which the interest rate is fixed, commonly called the “initial rate,” which can last from as little as a month to as much as 5 years. After that period, the rate can change. How frequently it can change is determined by the adjustment period. In the most common type of ARM, a 5/1 ARM, the initial rate is set for 5 years and the adjustment period is 1 year. This means that after the first 5 years of the loan, the rate can change every year.
ARMs look very attractive at first glance because they’re usually listed with much lower interest rates. That rate is only the initial rate, although there are a few limitations on how high the interest rate can go after that period. If interest rates go up, that adjustment can have you paying more once the initial term completes. However, if interest rates go down, an ARM can actually become less expensive!
The Index and the Margin
The adjustable rate isn’t set arbitrarily. They’re set by the rate of return on some major investment vehicle. The most common one is the London Inter-Bank Offer Rate (LIBOR). This is the interest rate that the world’s largest banks charge each other for short-term loans. Investors feel confident that these loans will be repaid, so the LIBOR is a benchmark for safe investments, like mortgages. This rate serves as the index for the ARM rate at many financial institutions.
Because individual home buyers are less secure than the world’s largest banks, investors take on more risk by putting their money into an ARM. To reflect that increased risk, ARMs also include a margin. This is an additional interest rate the lender tacks on to the index rate. The margin is typically locked in for the duration of the loan. The two together are the fully indexed rate, and that’s the rate you’ll be charged once the adjustments begin.
Periods and Caps
Fortunately, there’s a limit to how often a lender can change the rate of the mortgage. This adjustment period provides some measure of stability. Typically, ARMs don’t have adjustment periods that are any longer than one year (after the initial period) or any shorter than one quarter.
There are also limits on how much the interest rate can increase in one period, called a periodic cap. No matter how high the index goes, your interest rate can’t be increased in one period by more than a set percentage. If your ARM includes a 2% periodic cap, and the underlying index rate increases by 3%, your rate will still only increase by 2%.
That extra 1% isn’t gone, though. Many ARMs include a carryover provision, which means rate increases that were prevented by a cap may be applied during the next period. Even if the underlying index decreases, your rate could still be increased by any amount that was capped out.
Another kind of cap that exists for ARMs is the lifetime cap. These caps provide a limit on how high the rate can go during the term of the loan. If your initial rate is 6% and your ARM has a lifetime cap of 6%, your interest rate can never go above 12% no matter how high the underlying index rates get.
When are ARMs a good idea?
The riskiness of ARMs makes them a tough option for many people, especially on a primary residence. Unless you’re in a financial position to survive a mortgage payment doubling over the course of 10 years, an ARM can be hard to swallow. However, there are situations where the initial lower interest rate can make sense.
If you’re planning on selling the property before the initial period is over, the ARM can save you significantly on loan costs. If you intend to “flip” the house, or if your career involves frequent relocation, an ARM could be ideal for you. In this case, the gamble you’re making is less about the performance of an index and more about the performance of your area’s housing market. If demand drops, you could wind up holding on to an expensive mortgage or selling the house at a loss.
Some people choose ARMs because they plan to refinance after the initial period. The lower initial interest rates let them make extra principal payments, and they can then get better terms on a 15- or 30-year fixed rate for the remainder of the loan. This can also be a risky move if the value drops. The refinance may not be enough to cover the initial mortgage amount, leaving borrowers in a difficult position.
In general, choosing an ARM means planning to pay the balance of the loan before the end of the initial period. Otherwise, the unpredictability of the mortgage payment can make financial plans too complicated. Be sure to read and understand the terms of any mortgage, fixed or adjustable, before you sign!

Adjustable Or Fixed-Rate Mortgage – Which Is Right For Me

If you’re mortgage shopping, you may be overwhelmed by the number of options. Dozens of lenders, each with their own rates, terms, conditions and costs, can make the decision feel that way. But it doesn’t have to be that difficult! The choice of which mortgage to go with starts with a simple question: fixed-rate or adjustable? There are many different terms, points and rates associated with each, but narrowing your search to a category can really simplify the process.

As an overview, fixed-rate mortgages are the more traditional choice. You and a lender agree to a length of time (or term) and an interest rate. That interest rate stays the same throughout the term of the mortgage.

Adjustable Rate Mortgages (ARMs) are a slightly newer offering. These loans have a segment of time during which the interest rate is fixed. After that, the rate is determined by an economic indicator. If you’ve seen the notation “ARM 5/1,” that means an it is an adjustable rate mortgage with a set rate for the first five years of the loan, and then a new rate every year after that. There’s more to it than that, but this basic explanation will get us started.

So, which is the right one for you? The answer really depends on several factors.

How long do you plan to own your home?

One thing you’ll notice right away when shopping for mortgages is that ARMs have lower interest rates, sometimes by as much as 0.50%. On a $200,000 mortgage, that saves you as much as $70 a month! The initial rates are lower because the lender is taking on less risk. With a traditional mortgage, if rates go up, the lender is stuck with a lower return. With the ARM, you’re agreeing to pay more as the lending market offers more.

That doesn’t matter as much if you’re not planning on owning your home five years from now. If you’re in a line of work that moves you from place to place every few years, taking the monthly savings on an ARM and sticking it in your 401(k) is a good move. If you intend to buy the house, make some improvements and resell it for a profit, the ARM will lower your costs while you’re living there.

There’s still risk involved in the ARM even if you plan to sell the house. If demand drops in your neighborhood, you may have trouble finding a buyer. In that case, you’re stuck with the loan and a likely increasing interest rate. If you can find a buyer, but not for the price you paid for the house, the difference between the sales price and what you owe will follow you around, draining your monthly income until you finally get it paid off.

On the other hand, if you’re in your house for the long haul, the savings are likely to get wiped out once the adjustment period starts. ¬†Interest rates are at historic lows right now, and will likely increase in the next five years. The half-point savings in interest rates will seem trivial compared to the several-point increase you’ll face after the initial period.

How much can you afford to put down?

An ARM can be easier to qualify for and provides you with an interest rate that you might not get without a 20% down payment. If you don’t have enough cash on hand to make a large down payment, an ARM might give you some time to build equity. Refinancing your mortgage after the initial period is over can put you in a better position. You can use the equity you have in your home, plus whatever you’ve saved during that time, to put more money down and get a better fixed-rate mortgage.

Of course, this strategy is not without risk either. If the value of your home decreases, you may have a difficult time refinancing for the balance of the loan after the initial term. This would leave you stuck paying the higher interest rates of the ARM. If you can’t make the payments, you still lose your house, regardless of the equity you’ve established.

If you’ve got the cash to make a 20% down payment or are buying in an up-and-down housing market, a fixed-rate mortgage provides you with a good rate that you won’t need to worry about. Your mortgage payment stays the same from month-to-month and there’s no uncertainty about what global economies do in the interim.

What’s your risk tolerance?

At the core of the choice between fixed-rate and adjustable-rate mortgages, is a quick and dirty shortcut. Fixed-rate mortgages are the safer, more conservative choice. Adjustable-rate mortgages are the riskier alternative, but offer the possibility of savings.

If you have the room in your budget to accommodate a potentially fluctuating mortgage payment and enough security in your work, savings, and other financial priorities, an ARM does offer the potential to lower your monthly payment. If you’re confident that the value of your home will increase faster than interest rates, an ARM might be a wise investment.

If you’d rather have the security of a fixed-rate mortgage, there’s quite a bit to be said for that. If you’ve found the house you want to raise a family in, the stability of a fixed-rate mortgage may be desirable. If you’re trying to find the simplest path to homeownership, you may find the simplicity of the fixed-rate mortgage very appealing. It might be easier to be financially aggressive in other aspects of your life, and not put the place where you live at risk.