Did you know that there is more than one way to mortgage a house? Of course, most of us are familiar with the fixed variety. The buyer simply pays the same monthly payment over the entire term of the loan. There are certainly no surprises.
But adjustable-rate mortgages also known as an ARM do provide a viable option in the marketplace today. Before we get started, they aren’t for everyone and they do carry a risk
But don’t confuse an ARM with a subprime mortgage. The latter was offered to buyers with no income verification or very low credit scores. There were the types of mortgages that were heavily involved in the Financial Crisis.
Let’s talk about what an ARM mortgage is, who might best be served by one, and how they work in the marketplace.
An ARM Defined
There isn’t a trick or secret to how an adjustable-rate mortgage works. Unlike its conventional brethren, it has an interest rate that can change. This means your mortgage rate can go up or down.
Most consumers aren’t aware that the mortgage payment on your home could potentially go down. In this era of low-interest rates, no doubt there are plenty of consumers who are doing just that.
When the interest rate adjusts, this means your mortgage payment will as well. But let’s be clear, the only reason you would ever want to get into an ARM is for the lower mortgage rate. All ARM’s will start with a lower rate compared to a fixed or a conventional mortgage.
Inner Workings of an Adjustable Rate Mortgage
An ARM has several moving parts that potential consumers will want to be very familiar with. The ARM will start with a Teaser rate.
- This rate will be fixed for a certain amount of time. You can find this in your paperwork. It could be for as little as 1 year, or it could be for 3 or 5 years.
- Now after this period expires the interest rate is free to adjust. There will be caps built-in that will limit how much the rate can move both up and down.
- Now the vast majority of these types of mortgages will have several of these periods. This means you will need to be aware that your rate could potentially shift once a year.
Many consumers don’t fully understand how the Caps work in the actual process. So let’s get a little granular to clear up any confusion.
Caps are limits put into each ARM to limit the rate increases a mortgage could be subject to. This would limit how much the rate could go up each period and over the lifetime of the loan. Not only is this to prevent “shock value”, its also prevents consumers from losing their homes.
Initial Rate Cap
Remember that every ARM has an introductory Teaser rate that lasts for a fixed length of time. After this period expires, there will be a cap on how much the interest rate can change. This will be the first-rate adjustment.
Subsequent Rate Caps
Now adjustable-rate mortgages may have several adjustment periods. There will be limits again on how much the rate can change for each period as well.
For example, if mortgage rates were to spike 1% over a year, but yours was capped at .5%, the interest rate would only be able to increase .5% for that specific period.
Maximum Rate Caps
There is one final type of cap put into place that will limit how much the rate could increase over the life of the loan. If this rate is reached, yours can go no higher.
Consumers will want to look at their loan paperwork for the specifics of their rate increases.
What is the Benchmark Interest Rate
By this time you may be asking what determines whether my interest rate goes up or down. Each mortgage will be tied to a specific benchmark.
One of them is called LIBOR and for those who have loans tied to this index, it will determine whether or not their ARM adjusts. There are a few of these “benchmarks” and again your loan information should state which benchmark yours is tied to.
ARM Examples in the Wild
It’s important to understand the terminology when it comes to these types of mortgages
In this example, the Teaser rate lasts for 5 years. Then the rate will adjust for the 6th year and every year thereafter until the house is sold, refinanced, or you pay off the home.
Remember the rate is fixed for the first 5 years. So a buyer won’t have to worry about any adjustments.
Again, the Teaser rate will last for the first 36 months or 3 years. Starting the 4th year the rate will adjust and be fixed for years 5 and 6 as well. Then another adjustment will affect years 7,8 and 9.
There are both pros and cons to this latter arm. If rates were to surge halfway through year 4, the buyer would not feel any effects until potentially year 7.
However, the opposite is also true. If rates increased during year 3, the buyer’s interest rate would increase for years 4, 5, and 6. Even if the rate decreased during year 5, the rate wouldn’t reset until year 7.
There are all kinds of ARM options available to the consumer. The 1/1 probably offers the lowest interest rate but resets every 12 months.
Who It’s Not For
The ARM is certainly not for everyone. And it should be reviewed carefully before a final decision is made.
- Anyone on a fixed income who cannot afford a higher monthly payment certainly would not want this type of mortgage
- If you plan on living in your home for a very long time, then you would also be better off with the conventional type. The risk isn’t worth the reward.
- Knowledgeable buyers who are familiar with real estate realize that a certain neighborhood will be increasing in value in 3-5 years.
ARM: Who It’s For
- If you know that you won’t be living in your home for more than 5 years, then you would be an ideal candidate. Your employer may be moving you to a different section of the country.
- Maybe your income levels will be increasing in a few years. You did the math and you can afford the higher payments, and want to take advantage of the lower initial interest rate.
- The only reason you would ever want to entertain an ARM is for the initially lower interest rate.
- Which could save you a significant amount of money over time. You could sell your home or potentially refinance your home if you are afraid of higher rates in the foreseeable future.
- Anybody on a fixed income would want to steer clear of this type of financial tool.