They say that ignorance is bliss, but when it comes to mortgages, what you don’t know can hurt you. With rising interest rates, many borrowers will be offered an Adjustable Rate Mortgage (ARM) in order to keep mortgage payments more affordable. An ARM may be the right approach to being able to purchase a home, but as history has shown us Adjustable Rate Mortgage can create financial hardship for consumers who do not fully understand the risk.
Reasons to consider an ARM?
- On average, buyers live in their homes for 9 years. Why pay a higher interest rate for a 30 year fixed mortgage if you will only own the home for 9 years? Consider a 10/1 ARM, that has a fixed rate for the first 10 years of the mortgage.
- You want to purchase a home now, and have just started your career. Once you’ve gained more experience, your income will increase to be able to cover increased mortgage payments once your rate adjusts
- You are comfortable with risk: You should consider both your ability to sleep at night with the potential for change and your financial profile’s ability to handle unexpected expenses. Take a look at the “worst case” payment and when that could occur.
- You expect to be able to pay extra towards your mortgage over the years. Fixed rate mortgages are also fixed payment mortgages. Even if you pay extra, you are required to make the same payment amount each and every month until your balance is fully paid off. Adjustable rate mortgage payments are recalculated when the rate adjusts meaning that if you are able to substantially pay down your mortgage, your required payments will reflect the lower balance and can decrease.
Key ARM Vocabulary:
Loan Term: This is the LENGTH of the mortgage, not the period of time that the interest rate is fixed. Typically 30 years. A 30 year mortgage is not necessarily a 30 year FIXED mortgage.
PRODUCT: “Fixed Rate” indicates that the interest rate is fixed for the life of the loan. ARMS will be described as 5/1, 7/1, or 10/1 and less frequently 5/6, 7/6, or 10/6. This indicates the number of years that the interest rate is fixed (5 years, 7 years or 10 years) and how frequently the rate will adjust after that fixed rate period. A “1” indicates one year. A “6” indicates every 6 MONTHS. The new Consumer Disclosures implemented in October of 2015 very clearly identify if the interest rate can change or not.
Index: The economic index that will be used to calculate rate adjustments. Typical indices used are LIBOR, Prime, and Constant Maturity Treasury – most can be found in the WSJ or online: http://mortgage-x.com/general/mortgage_indexes.asp
Margin: Typically 2.25 or 2.5. This is set for each mortgage product and is added to the index to calculate the new interest rate when it is scheduled to adjust.
Prior to the housing crisis, Margins were frequently tied to lender compensation, especially with “Option ARMS” which had very low start rates and the possibility of negative amortization. The higher the margin, the higher the yield spread premium paid out to the Loan Officer. Because this is not calculated into the start rate it was not apparent to the borrower until the first rate adjustment and the rate increased dramatically. With new lender compensation regulations in place, this practice is no longer allowed.
However, an ARM with a margin of 3 should be considered more risky than an ARM with a more typical margin of 2.5.
Rate Caps: Interest rate increases are limited by rate caps established on a product by product basis. These caps are expressed as “initial” “periodic” and “life of the loan”. A typical ARM rate caps would appear as “2/2/5” which is translated to an initial rate cap of 2%, meaning the first rate adjustment maximum is 2%. If your start rate was 4.5%, the maximum rate would be 6.5%. Each rate adjustment after the initial adjustment would also be limited to a 2% increase, so the maximum rate on the 2nd adjustment is 8.5%, up to a maximum life of the loan increase of 5%, so the maximum interest rate would be 9.5%.
It is important to remember that adjustments can also result in a lower payment if the underlying index drops (typical in poor economic times). New payments are calculated based on the new interest rate, the remaining loan balance and the remaining loan term.
Want more information? Click here for the Federal Reserve Consumer Handbook on Adjustable Rate Mortgages: https://www.federalreserve.gov/pubs/arms/armstext_cover2005.pdf