Key Aspects of Adjustable Rate Mortgages
As the name suggests, an adjustable rate mortgage (ARM) is one with a fluctuating interest rate. Many people find these too risky, preferring to opt for a conventional fixed rate mortgage. An ARM, however, can provide some real financial benefits in certain situations. Before considering an ARM it is best to understand the key aspects of these mortgages, as they are certainly higher-risk than the fixed rate variety.How ARM Interest Rates are Calculated
The interest rate on an ARM is linked to an economic index. In the US, there are six commonly-used indices, including the London Interbank Offered Rate and the Cost of Funds Index. The index increases and decreases according to economic activity, and the interest rate on the ARM adjusts accordingly. Depending on the terms and conditions of each ARM, these adjustments might be made annually, or two to three times a year.
The interest rate a lender quotes is made up of the index figure plus a margin that represents the profit the lender makes on your loan. Unlike the index, the margin usually stays constant throughout the life of the ARM. Your mortgage note will include this information, stating the index your interest rate is based on, as well as the margin.
Adjustment Periods
The adjustment period of an ARM is the time between interest rate adjustments. In most cases, this is one year, but can be as low as one month. Most ARMs are hybrid mortgages, amortized over a thirty year period. This means for the first few years, the interest rate is fixed, and after that initial period, the interest rate becomes adjustable. In advertisements this is often represented as, for example, 3/27, which means that the mortgage has a fixed interest rate for the first three years, and the rate is adjustable for the remaining 27 years. Note, however, that a 5/6 ARM does not follow this pattern. This one still has a thirty year amortization period, but the adjustment period is six months.
Payment Caps
ARMs have payment caps, meaning there is a cap on how much the interest rate can increase or decrease at each adjustment, and over the life of the loan. There are three different types of caps”initial, periodic, and lifetime caps. Initial caps limit the amount an interest rate can change by at the first adjustment, period caps limit the rate change for each subsequent adjustment, and lifetime caps limit the amount the interest rate can change by over the life of the loan.
For example, if the ARM has a 5/2/6 cap, this means that at the first adjustment, the interest rate can increase or decrease by up to 5%. The rate can change by up to 2% at each subsequent readjustment, but over the life of the loan the interest rate can never deviate more than 6% from the initial interest rate.
Option ARMs and Negative Amortization
Option ARMs allow the borrower to make different types of payments for any given month. They may, for example, choose to make an interest-only payment one month, or even make a payment that is less than the interest owing for that month. These types of ARMs are popular because they offer very low initial interest rates and low minimum payments. The danger, however, is that negative amortization becomes possible with an Option ARM. This is a situation in which the payment made for that month is less than the interest that accrued, and this unpaid interest is then added to the balance of the principal. When the balance increases, the amount of equity the borrower has in the home decreases accordingly. In the most severe situations, the borrower may end up owing more than the property is worth.
Refinancing out of an ARM
People who refinance an ARM in favor of a fixed rate mortgage usually do so for one of three reasons. They may have taken out an ARM with the intention of living in the house for only a few years. If their plans change and they decide to live in the house for the long term, they may refinance to a fixed rate mortgage because it provides greater financial stability. Alternatively, if interest rates start to rise and look set to increase in the long term, it’s sensible to refinance before increasing interest rates affect fixed rate mortgages significantly. Finally, some people just realize that the instability of an ARM isn’t for them”they prefer to have a fixed rate mortgage because fixed monthly repayments allow for more long term financial planning.
If you’re thinking of refinancing out of an ARM, don’t forget that there will be a new round of closing costs to pay on that second mortgage. In most cases they’re payable in cash at closing, and having to pay closing costs might entirely negate the benefits of the lower interest rate on the ARM. Refinancing generally shouldn’t be attempted without a good reason unless you know you’ll be living in the house for at least long enough for the lower interest rate to recoup your closing costs.
