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 There's a common misconception that adjustable rate mortgages are only for consumers that really can't afford a fixed rate mortgage. While that fact may seem true - it's not. An adjustable rate mortgage, or ARM, can play an important role in the real estate market, especially to the savvy homeowner.
In this article we're going to first explain what consumers can expect to find in the adjustable rate mortgage marketplace. We're also going to explain some of the pros and cons of this type of mortgage. Then we'll finish up by providing you with some online tools where you can compare ARMs to more traditional mortgage offerings.
What is an ARM?
An adjustable rate mortgage is one where there is a variable rate of interest applied to the mortgage payments. The interest rate is adjusted on a predetermine basis and is usually varied with an index of inflation. The benefit of an ARM to consumers is that lenders are able to offer lower rates of interest on the mortgages they write. They can do so because they've shifted the risk of rising interest rates to the borrower.
Variable Interest Rates
As just mentioned, an adjustable rate mortgage is adjustable in terms of the interest rate charged the borrower. The rate of interest charged usually moves in step with a well known indicator of inflation. The terms and conditions of the ARM will usually state which index is used.
The most common indexes used for ARMs include:
- National Average Contract Mortgage Rate
- Constant Maturity Treasury or CMT
- Treasury Average Index (12 month TCM)
- 11th District Cost of Funds Index or COFI
- London Interbank Offered Rate or LIBOR
- Prime Lending Rate (plus)
When a prime lending rate is used, the index is usually based on a prime plus a margin basis - meaning the interest rate charged will carry a premium (be higher) over the prime interest rate
AMR Adjustment Caps
In most instances, the terms of an adjustable rate mortgages will also include two "caps" or maximum allowable adjustments to the interest rate on the loan. The most common caps apply to:
- The overall rate of interest charged - sometimes referred to as the lifetime cap.
- The amount by which the interest rate can be adjusted in any one period.
This concept of these moving interest rates is best explained using an example.
Adjustment Cap Example
In this example, the ARM's terms and conditions are for a $100,000 mortgage, with an initial interest rate of 5.50%, a 12.00% lifetime cap and a 1.00% cap on adjustments.
What this means is that the interest rate on the loan can never exceed 12.00%. And in this example, the rate of interest charged after the first adjustment cannot exceed 6.50% or 5.50% + 1.00%.
Frequency of Rate Change
Adjustable rate mortgages will also indicate the allowable frequency of change to interest rates. Here again, the terms of the ARM will usually specify two variables with respect to this change:
- The timeline until the first allowed change in rates - sometimes referred to as the resetting date.
- The time until subsequent allowable changes.
Here again, the best way to explain this concept is by using an example.
Rate Change Example
We're going to simply expand on the previous example we just used. But this time we're going to explain further that this mortgage started in the year 2005 and it was a 5 Year ARM with a 12 month subsequent adjustment period.
So in this example, the first adjustment to interest rates cannot occur before the year 2010 - the resetting date. However, every twelve months after 2010, the lender is allowed to make additional adjustments.
ARM Quotes
When ARM loans are quoted in the newspaper or online, you'll usually see them stated in a way that provides information on the frequency of change as well as the interest rates. For example, a 3/1 ARM indicates three years until the first adjustment and one year for each subsequent adjustment, while a 5/1 ARM allows the borrower to own the mortgage for five years until the adjustments begin.
Common Variations of ARMs
In today's mortgage marketplace, there are two additional variations of the ARM that are worth talking about - the hybrid ARM and the option ARM. As a new home owner it's important to understand the terms and conditions of an option ARM because this type of loan can actually result in what's called a negative amortization. Simply put, the loan can grow over time - not decrease.
Hybrid Adjustable Rate Mortgages
A true adjustable rate mortgage is a loan where the interest rate adjusts on a consistent and predetermined basis - for example a one-year ARM. Hybrid ARMs are actually quite common and the example used earlier is actually a Hybrid. The term refers to the fact that the loan is at a fixed rate of interest for a period of time and then floats later on.
So a 5/1 ARM is a hybrid that carries a fixed rate of interest for the first five years, then a floating rate of interest afterwards.
Option Adjustable Rate Mortgages
An option ARM is a loan that allows the borrower to choose how they would like to make a payment each month. Option ARMs can include three or more "options" or choices:
- A predetermined minimum payment.
- An interest-only payment.
- A fixed rate of interest payment.
Option ARMs often are marketed carrying an extremely low rate of interest to lure consumers to the loan. And the minimum payment feature found on this type of mortgage results in negative amortization of the loan. Which simply means the outstanding loan amount, or principal, is increasing over time rather than decreasing.
Pros and Cons of ARMs
While on the surface it might seem that adjustable rate mortgages are better suited for first time home buyers that cannot afford to make the monthly mortgage payments on a fixed rate mortgage, that's simply not true. They really do serve a valuable role in the marketplace.
Pros of ARMs
Perhaps the biggest benefit of an ARM is the low rate of interest these mortgages typically carry. This rate is really just a reflection of the fact the risk of rising interest rates is shifted from the bank, mortgage company, or lender, to the borrower. And since the borrower now bears the risk of rising interest rates, the loan can be initially written at a lower rate.
Another big benefit of ARMs applies to those homeowners that do not anticipate living in a home for a long period of time. It is not unusual for employees to be assigned to certain geographies for five years or less. In addition, the first time home buyer may purchase a house knowing they are not going to live in that home for more than three to five years.
In both of these examples, the homeowner is planning on selling the home before the adjustment period / resetting date begins. In this situation, they reap the benefit of lower interest rates and the risk of an adjustment is minimized or eliminated.
Cons of ARMs
The biggest down side of ARMs is that they can give the homeowner a false sense of security about their family's financial health. Individuals might buy homes and stretch themselves financially by taking out a loan that they can barely afford in the hope that they will be able to find the money before the ARM starts adjusting. This is, in fact, a very real danger that exists with this type of mortgage.
If you're thinking about choosing an ARM, then do it for the right reason. Don't be fooled into thinking you're going to get a new job and your income is going to rise dramatically. Make sure you work with your lender and they outline for you the maximum monthly mortgage payment possible with each loan type you're evaluating.
Mortgage Calculators
If you're mortgage shopping and you want to compare mortgage offers, we've got a complete line of online mortgage calculators that can help. We have tools that can help you compare mortgages and even figure out how much mortgage you qualify for. We've even got an ARM calculator.
If you're thinking about refinancing a mortgage we can help there too. All of our mortgage calculators come with detailed instructions and, where appropriate, provide help to the user in interpreting the calculator's results.
About the Author - Adjustable Rate Mortgages
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