Understanding Adjustable Rate Mortgage or ARMs
Written by: Kristy Welsh
Last Updated: August 10, 2017
If you are in the market for a house, you will want to choose the right type of home mortgage loan that will fit your needs and financial situation. Banks and mortgage brokers offer a wide variety of home loan products and finding the right one can be tricky as some loans carry some good options and some carry some very bad options. Now that you've scoured the housing market for the perfect house, you now need to scour the mortgage loan industry for the perfect home loan. One such type of home loan product is an adjustable rate mortgage or what is more commonly referred to as an ARM. Is this home loan right for you? Read on to find out more about this loan and if it will be a good fit for your home buying needs.
What is an Adjustable Rate Mortgage or ARM?
An adjustable rate mortgage is pretty much what it sounds like - a home loan with an interest rate that can adjust periodically. A fluctuating interest rate means your monthly payments can go up or down, which makes it difficult to predict what your payments will be in the future. Today, when you take out an ARM, it is not a purely adjustable rate but a sort of hybrid ARM. That means, it starts out with an initial fixed-rate period and then changes into a pure adjustable rate. The most popular adjustable rate mortgage is the 5/1 ARM, which means:
- The first 5 years are at a fixed interest rate. (That's the "5" in 5/1.)
- After that, the interest rate can change every year. (That's the "1" in 5/1.)
Lenders also offer 3/1 ARMs, 7/1 ARMs, and 10/1 ARMs. Picking the right ARM depends on how long you plan to stay in the home you are buying and your financial situation.
Details You Need to Understand About ARMs
As with anything, the more informed you are about a topic the more you understand the ins and outs on that subject and the better decision you will make. This could not be any truer than with an adjustable rate mortgage. The most important aspects of an ARM you need to understand is index, margin, and caps. So, let's dig into each one so you will be able to make a well informed decision when it comes to using an ARM or not.
What is an index? After the fixed-rate period of your loan is over, your interest rate adjusts based on the index the lender uses. There are several indexes used with the most common ones being Constant Maturity Treasury, 11th District Cost of Funds Index (COFI), and the London Interbank Offered Rate, or LIBOR. The value of these indexes change from month to month and can be found in the financial pages of most newspapers or online.
What is a margin? Lenders add a margin, which is a fixed percentage rate, on to the index. The margin is set at the start of your loan, and it never changes. You will need to know what the margin is to determine whether you can handle the payments when your loan adjusts. For example, say your index is LIBOR, which has a value of .86 on the day your loan adjusts. You have a margin of 2.25. Your new interest rate is going to be 3.11 percent and you will be jumping for joy if your loan had started at 3.625 percent.
What are caps? To keep your ARM from shooting out into the stratosphere, financial institutions put caps into place: the initial cap, the annual cap, and the life cap. The caps on your loan will be displayed like this 2/2/6, for example. Using this example, the first number (initial cap) is the maximum the interest rate can go up on the first adjustment. So, if you started at 3.25 percent, the max it would go up to would be 5.25 percent. The second number (annual cap) is the cap for every subsequent adjustment the rate can increase by above the rate during the previous period. Let's say your rate adjusted to 3.75 percent from 3.25 percent during the first adjustment. When your ARM adjusts in the next year, it is capped at 5.75 percent. The third number (life cap) in our example, 6, means the rate can never go higher than 6 points above the start rate. So if your starting rate was 3.25 percent, your rate will never go any higher than 9.25 percent.
How often can your loan adjust? To know this, you need to look at the type of ARM loan you have on your house. If, for example, you took out a 5/1 ARM, that would mean your loan will be fixed for 5 years and would adjust every year thereafter. If you took out a 5/6 ARM, your loan would be fixed for 5 years but adjust every 6 months.
How Will an ARM Benefit You in the Long Run?
The most obvious benefit of taking out an ARM rather than a fixed-interest rate loan is the lower starting interest rate. Looking at rates as of the writing of this article, a 30-year fixed mortgage rate was 3.45 percent and a 5/1 ARM was 3.13 percent. If you are not planning to live in this house for longer than 5 years, taking out an ARM will save you money with a lower monthly payments. You can get ARMs in 5, 7 or 10 year increments so if your plan is to sell your house within that time frame, an ARM is the better way to go. If you are planning on staying in the house until you die, taking out a fixed-interest rate loan is the better choice.
If you stay in your house longer than the initial fixed-interest rate period, you run the risk of your interest rate going up and your monthly payments increasing. On the flip side, your interest rate could decrease hence lowering your monthly payments. If you are a gambling type of person, this roll of the dice might appeal to you. But be warned, your luck may only last for a short while so you will need to be prepared if the rates suddenly shoot up due to catastrophic economic circumstances - remember 2008?
Buying a house is exciting and exhausting. Our advice to you during this busy time is to take the time and research all the available home loans and make sure you are getting the mortgage loan that is best for you. Putting as much effort into getting the best loan as you did into finding the perfect house, will pay off for you financially in the long run.