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Adjustable Rate Mortgages (ARM)
There is a lot of confusion regarding adjustable rate mortgages
(ARMs).
Even though these mortgages have a variable interest rate that fluctuates according to the
index, research has shown that borrowers who got ARMs tended to pay less in interest than
borrowers who chose 30 year fixed rate loans.
ARMs are most useful to home buyers who plan to stay in their homes only
five to seven years. If you compare a worst-case scenario ARM (where the interest rate
rises to its cap each year) with a fixed rate mortgage, you will usually do as well or
better with an ARM over the short run.
Borrowers should be aware of the following
factors when considering an ARM:
Adjustment period: By definition, an
adjustable-rate mortgage has the potential for rate and payment changes at specific
predetermined periods, usually every year, every three years or every five years. Other
adjustable periods vary from six months to 10 years. Some ARMs combine two adjustment
periods. For example, a 3/1 ARM has a fixed rate for the first 3 years and then adjusts
annually for the remaining life of the loan.
Caps: Caps are limits placed on payments,
interest rates and/or the balance of a loan. Caps can limit increases by either a dollar
amount or a percentage. The most common interest rate caps specify a 1% or 2% maximum rate
increase per adjustment and a 5% to 6% maximum rate increase over the life of the loan.
Index: The index is a measurement used by
lenders to determine changes to the interest rate charged on ARMs. Indexes are based on a
published, independent measure of current interest rates, such as Treasury Bills, West
Coast Cost of Funds (11th District) and LIBOR (London Inter-Bank Offering Rate). The index
provides a guideline that should accurately reflect the current cost of lending money. If
the index increases, the interest rate increases unless an interest rate cap is reached.
Margin: The margin, which is added to the
index to compute the interest rate, represents the lender’s cost of doing business
plus profit. This amount is typically two or three percentage points. Once the lender
specifies the margin, it remains fixed.
Only applicable for
buyers who intend to purchase the home as a primary residence.
Advantages |
Disadvantages |
| With an adjustable rate mortgage,
the interest rate goes up and down. If rates are high and likely to fall, this is an
advantage. In addition, the initial interest rate on an ARM is typically 1 to 3 percent
lower than traditional fixed-rate mortgages. Also, payments are recalculated after each
adjustment period based upon the remaining principal. This is particularly attractive if
the borrower will be making additional principal payments each year. |
If rates go up, so does the
interest rate for that adjustment period and the monthly payment can and probably will go
up. This could be as high as two percent per adjustment period. Unlike the traditional 30
or 15 year mortgages, adjustable rate mortgages do not have the security and fixed payment
over the life of the loan. |
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