Adjustable Rate Mortgages (ARM)
What is an ARM/Adjustable Rate Mortgage?
Adjustable rate mortgages (ARMs) differ from fixed rate mortgages (the more traditional mortgage) in that the rate of the loan changes over the life of the loan. What does this mean to you? That means that the rate of interest you are paying when you start (let's say 4.25%) doesn't remain the same for the life of the loan. It could go up (to 4.50%, for example) or down (to 4.00%). That means that your monthly payments may also go up or down.
Is an ARM more risky than a traditional fixed rate loan?
Yes, but like all risk, there are benefits paid for taking this risk. For one, the starting interest rate will be lower when you first take the loan. This can be a saving grace if you're already stretched thin (financially speaking) when making a new home purchase. If a rate adjustment does occur, it can happen after you've had time to absorb all of the new home expenses (furniture, moving costs, landscaping, repair, etc.)
Also, for the last 5 years, people with ARMs have won financially over those with fixed rate loans. Since the rates have stayed low, the ARMs have either stayed the same or adjusted downwards, so those with ARMs have paid less interest than their fixed-rate peers.
On the negative side, the rate will adjust, so if interest rates climb, you may end up paying more interest than if you had locked in the rate with a fixed mortgage.
Does that mean with an ARM, my rate can go through the roof?
Probably not. Most ARMs have two different types of rate caps: a yearly cap and a lifetime cap. The yearly cap limits the amount that the rate can increase in a given year. The lifetime cap limits the amount the rate can increase across the full lifetime of the loan.
So, if you have a rate of 4.25% with a yearly cap of 2% and a lifetime cap of 9%, even if the rates skyrocket into the double digits (unlikely), the maximum rate you will have for the 1st year will be 6.25%. Over the lifetime of the loan, your rate will max out at 9%. While this may seem high, realize that it's a worst case scenario. It's more likely that your rate will go up one or two percentage points in the next decade.
A lender told me I could get a rate of 1.125%. How can they offer a rate this low?
This rate is known as a “teaser” rate and is generally only in effect for the first 6 months of the loan. Then the rate progressively jumps to the real ARM rate of the specified loan. Some people have told me, “I've seen my loan documentation and it shows this low rate and nothing higher.” That's because the low rate WILL be your start rate and that is the only known rate at the time you sign your loan docs. The real rate that the loan will adjust to is calculated from a loan index plus the loan margin.
Loan index? Margin? What are those?
The rates of all adjustable rate mortgages are determined by using a mortgage index. In the stock market, the Dow Jones Average provides a stock index that gives a general overview of how the market is performing. In the mortgage industry, there are several indexes that average mortgage interest rates. These indexes are used by lenders to determine the rates of adjustable mortgages. Popular indexes include the index of U.S. Treasury Bills, LIBOR, COFI, and COSI. Indexes are not controlled by the lender.
A margin (also called a spread) is the percentage over the index that will determine your rate. For example, if your loan has a margin of 1% and the current LIBOR is 3.95%, then when your loan adjusts, it will adjust to 4.95%. The lower your margin, the lower your overall rate. Margins are generally in the 2-4% range.
So are those low interest rate (1%, 1.125%, 1.5%, etc.) loans a good deal?
For most situations, they aren't. When your mortgage adjusts, usually within 6 months to a year, your monthly payment can jump quite a bit (because the rate will adjust to sometimes 2-4% higher than the start). The margins on these loans tend to be higher since the lender has to make up the money lost in the beginning of the loan when the money was lent at below market rates.
However, there are situations when these low starter rate programs can be good. Some lenders offer attractive margins and suitable rate caps that for certain types of situations they can be useful (where the absolute minimum monthly payment is needed in the beginning). For most situations, though, these loans are more expensive then traditional ARMs.
What is the ARM adjustment period?
An Adjustable Rate Mortgage does not adjust constantly. Instead, the rate and mortgage payment adjust after a given time know as the “adjustment period.” The most common adjustment period is 1 year where once a year, the loan rate adjusts to the index + margin. Some adjustment periods are as low as one month, but these are very rare.
What is a 3-year ARM? A 5-year ARM?
Lenders offer loans that combine a fixed rate period with a later adjustment period. With this type of ARM, the rate is fixed for a certain period (usually 3 or 5 years) before it goes adjustable.
This gives borrowers stable low interest rates in the beginning and then allows the rate to become adjustable after the borrowers are more established in their home. It also allows real estate investors who only plan to keep a property for a certain length of time the dual advantages of stability and a lower rate than a 30-year fixed loan.
What is an Interest Only loan?
An Interest Only loan (or IO loan) generally provides the absolute lowest monthly payments. Instead of paying the interest and paying off a certain portion of the principle every month, only the interest is paid. Of course, that means that the principle balance is not being paid down on the mortgage.
So how is the principal amount paid off?
Interest Only loans usually require a balloon payment for the overall amount at the end of the loan. Interest Only loans are used primarily by real estate investors or people who plan to stay with a property for only a specific (and planned) length of time. That means that the property will be sold before the balloon comes due, at which time the loan will be completely paid off with the proceeds of the sale. People with IO loans can alternately refinance into a traditional mortgage before the balloon comes due.
What is a payment cap?
Some adjustable loans, in addition to rate caps, have payment caps. A payment cap will limit the amount of the maximum monthly payment. That means that if the rate were to jump 2% in one year but the loan terms contains a payment cap, the mortgage payment may not rise to that full 2 percent.
For example, say a borrower had a $300,000 mortgage currently at 5%. That would make the monthly mortgage payment about $1600. Let's further say that the ARM had a payment cap of $1800. If the rate jumped 2% in this example, the new payment would be almost $2000. However, since the payment cap is $1800, the monthly payment would only go to $1800.
Sounds great, doesn't it? The only problem is that the monthly difference of $200 doesn't go away. Instead, the loan enters something called “negative amortization.”
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