Adjustable Rate Mortgages (ARMs)
An ARM is a mortgage with an interest rate that is linked to an economic index. The interest rate--and your payments--are periodically adjusted up or down as the index fluctuates.
ARM Terminology
Index
An index is a guide that lenders use to measure interest rate changes. Common indexes used by lenders include the activity of one, three, and five-year Treasury securities, but there are many others. Each ARM is linked to a specific index.
Margin
Think of the margin as the lender's markup. It is an interest rate that represents their cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. It usually stays the same during the life of the loan.
Adjustment Period
The adjustment period is the period between potential rate adjustments.
- You may see an ARM described with figures such as 1-1, 3-1, and 5-1. The first figure in each set refers to the initial period of the loan, during which your interest rate will be the same as it was on the day of closing.
- The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The examples above are all ARMs with annual adjustments.
If my payments can go up, why should I consider an ARM?
The initial interest rate for an ARM is lower than that of a fixed rate mortgage--where the interest rate remains the same during the life of the loan. A lower rate means lower payments, which might help you qualify for a larger loan.
Other Issues to Consider
- How long do you plan to live there? The possibility of higher rates isn't as much of a factor if you plan to be in the home for a relatively short time.
- Do you expect your income to increase? If so, the extra funds may cover the higher payments that result from rate increases.
- Some ARMs can be converted to a fixed-rate mortgage. However, conversion fees may be high enough to take away all of the savings you saw with the initial lower rate.
- While you can't dictate which index a lender uses, you can choose a lender based on which index will apply to your loan. Ask how each index has performed in the past. Your goal is to find one that has remained fairly stable.
- When comparing lenders, consider both the index and the margin rate being offered.
- If the lender doesn't plan to sell your loan on the secondary market, you might be able to avoid the Private Mortgage Insurance (PMI) that's normally required when a buyer makes less than a 20% downpayment.
Reducing Your Risks
Consider the following issues before accepting an ARM.
Discounted Rates - Buydowns
Sellers sometimes pay a fee that allows the lender to offer you an initial rate that's lower than the sum of the index and the margin. The buydown rate will eventually expire.
The Double Whammy
Your payments can rise significantly if your rate is adjusted upwards at the same time the discount expires.
Is a Discounted Rate Worthwhile?
Sellers may raise the price of a home by the amount they pay to buydown your loan. The extra cost may in time override any savings from the initial discount.
Interest Rate Caps
Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.
Periodic caps limit the amount your interest rate can increase from one adjustment period to the next. Not all ARMs have periodic rate caps.
Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.
Payment Caps
A payment cap limits how much your monthly payment can increase at each adjustment. ARMs with payment caps often do not have periodic rate caps. Carryovers
If an interest rate cap has held your interest down even though the index went up, the amount of the increase can be carried over to the next adjustment period.
Negative Amortization
Amortization takes place when payments are large enough to pay the interest due plus a portion of the principle.
- Negative amortization occurs when payments do not cover the cost of interest. The unpaid amount is added back to the loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the loan.
- Negative amortization generally occurs when a loan has a payment cap that keeps monthly payments from covering the cost of interest.
- Negative amortization does not have as much of an impact when real estate is appreciating nicely, so the lower payments may be more attractive to you than paying down the principle.
The Bottom Line
Lenders are required to give you written information to help you compare and select a mortgage. Don't hesitate to ask as many questions as it takes to help you understand every aspect of your loan.
