Money Girl goes under the hood of ARMs to see how they really work.
Buying a home is one of the biggest financial decisions you’ll ever make. Not only do you need to choose a property that’s a good fit for your lifestyle, but you also need to choose the best mortgage. In this episode you’ll learn important features of adjustable-rate mortgages so you’ll know if it’s the right loan for you.
What Is an Adjustable-Rate Mortgage (ARM)?
Mortgages can seem pretty confusing—but when you boil them down there are just 2 main types: adjustable-rate and fixed-rate. Fixed-rate mortgages are pretty straightforward because the interest rate and monthly payment never change, no matter what.
Adjustable-rate mortgages or ARMs are more complicated because the interest rate can adjust or change periodically. That means you have to consider the maximum amount an ARM payment could go up and if you could afford the increase.
Additionally, there are several different types of ARMs. To know the issues that an ARM borrower could face, let’s get under the hood of these products so you understand how they work. Here are 7 important features of ARMs:
Feature #1: The Index
The reason ARM interest rates fluctuate is because they’re linked to a common index, such as the London InterBank Offered Rate (LIBOR) or the Monthly Treasury Average. If the index moves up, your interest rate generally increases, which means you have to make higher monthly payments. On the other hand, if the index drops, your payment typically goes down.
Feature #2: The Margin
The margin is a set number of percentage points that a lender adds to the index rate. For instance, if the index is currently 2% and the margin is 2%, then the fully indexed rate you pay is 4%. And if the index rises to 3%, the additional margin of 2% makes the full rate 5%.
Some lenders base the amount of margin they charge on an ARM on your credit. The better your credit score the lower the margin, and the less you have to pay for the mortgage. So when comparing ARMs always look at both the index and the margin percentages.
Related Content: Best Tips to Improve Your Credit Score
Feature #3: Initial Rate
When you get an ARM, there’s generally a discounted introductory interest rate, called the initial rate, that could last from one month to 5 years or more. The initial rate on an ARM can make it appear much less expensive than other loan options—but don’t assume that makes it the best choice for you.
If you don’t understand when and by how much your mortgage rate could increase, you could be in for a shock if there’s a sudden and perhaps unexpected spike in your monthly payment.
Feature #4: Adjustment Period
To know how often the interest rate and payment of an ARM could adjust, you simply need to look at the product name. For instance, a 1-year ARM can change interest rates once a year. A 3-year ARM can change rates once every 3 years.
Feature #5: Caps
In addition to knowing how often an ARM rate could change, you need to understand how high it could go. There are 3 different limits or caps on the amount your rate and payment could increase:
Periodic adjustment cap limits the amount an ARM rate can shift up or down from one adjustment to the next. For instance, if you have a periodic cap of 2%, and you’re paying a rate of 4%, then the highest rate you could be charged at the next adjustment is 6%.
Lifetime cap limits the amount an ARM rate can go up over the life of the loan. For instance, if you have an initial rate of 3% and a lifetime cap of 6%, the rate can never exceed 9%.
Payment cap limits the amount your monthly payment can increase from one adjustment to the next. For instance, if you have a payment cap of 7% and a monthly payment of $1,000, then it could only go up to $1,070 (7% of $1,000 is an additional $70), even if the interest rate rises more.
Feature #6: Different Types
If margins and caps sound like a lot of mortgage jargon to grasp—but wait, there’s more! Additionally, there are different types of adjustable-rate loans. Here’s a brief overview of 3 common types, the hybrid, the interest-only, and the payment-option ARM:
Hybrid ARMs are a mix or hybrid of a fixed- and adjustable-rate loan. The interest rate is fixed for the first few years and then the rate may adjust on a periodic basis. For instance, a 5/1 ARM means that it’s fixed for 5 years and then adjusts every year until the loan is paid off.
Interest-only ARMs allow you to pay just interest for a specified time, such as 3 to 10 years. This gives you smaller payments at first but larger payments later on because you have to start paying back the principal as well as the interest each month.
Payment-option ARMs give you several choices for how to make a payment each month. They typically include paying interest-only, principal and interest, or a minimum payment that may be less than the amount of interest due.
Feature #7: Negative Amortization
When you don’t cover the amount of interest owed each month, you get into a dangerous situation known as negative amortization. With negative amortization your unpaid interest gets added to your mortgage balance, so instead of paying down your loan, you end up owing more than you originally borrowed.
Is an ARM Right for You?
Getting caught in a cycle of negative amortization means an ARM could actually cost you an arm and a leg! But does that mean ARMs are too risky and should never be considered? Not necessarily.
On the flip side, a fixed-rate mortgage offers stability, but comes at a cost because the interest rate is higher than an adjustable -rate product. Right now the average interest rate on a 30-year fixed mortgage is 3.55% and a 5/1 ARM is 2.87%.
The best way to know whether you should consider an ARM is how long you plan to own the home. If you’re likely to sell it within a few years, the upside of having low ARM payments generally outweighs the downside of potential future rate increases.
Plus, the typical mortgage is paid off or refinanced within 7 to 10 years. So, if you’ll only have a mortgage for a relatively short period of time, why pay a premium for a 30-year fixed mortgage? Choosing a hybrid loan like a 5/1 ARM gives you a fixed payment for the first 5 years with no risk of a rate increase until the sixth year.
Having potentially higher ARM payments in the future may be manageable if you expect your income to increase or if you already have plenty of income and savings. You can also budget for a rate increase and bank the savings you get each month from choosing an adjustable over a fixed-rate mortgage.
However, if you’re not likely to be so disciplined with your finances, you don’t know how long you’ll stay in a home, or you just prefer a fixed budget, a fixed-rate mortgage is the way to go.
Quick and Dirty Tip: Since mortgage rates are at or near historic lows, they have nowhere to go but up. So the key to using an ARM successfully is to understand exactly how much it could go up and whether the worst-case scenario is still a good move for your finances.
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Photo attribution: Real Estate Mortgage photo from Shutterstock