Adjustable Rate Mortgages - A Guide
to ARM Loans
by Brandon Cornett
Many home buyers choose the adjustable
rate mortgage (ARM) in order to save
money during the first few years
of homeownership. But later, these
same homeowners run into trouble
when the adjustable rate mortgage
adjusts (hence the name) to higher
interest rates.
In many cases, such adjustments
can greatly increase the size of
the overall mortgage payment, which
catches a lot of homeowners off guard.
In this guide, we will examine the
adjustable rate mortgage in more
detail. After reading this guide,
you will better understand the ARM
loan and will be able to make wise
decisions about such loans.
What Is an ARM?
As the name implies, an adjustable-rate mortgage differs from a fixed rate
mortgage in the way it adjusts to a new interest rate at some future point
in time. Fixed rate mortgage loans carry the same interest rate through the
entire life of the loan. So the interest rate you would pay in Year 1 would
be the same rate as years 5, 10, 15 ... all the way through the end of the
loan's term. On the other hand, with an adjustable rate mortgage, the interest
rate will change periodically. This can cause payments to go up or down,
depending on the prevailing rate at the time of adjustment (and other factors).
In other words, an adjustable rate
mortgage is a loan with an interest
rate that changes at some point in
the future. Most of the time, ARM
loans start off with a lower monthly
payment than a fixed rate mortgage.
But keep the following points in
mind:
- Unlike a fixed rate mortgage,
the payments on an adjustable rate
mortgage can change. This can increase
the size of your mortgage, sometimes
significantly.
- You cannot predict what the interest
rates will do three or five years
from now, when your ARM loan adjusts.
- It's possible that you could
eventually owe more money than
you borrowed.
- If you want to pay off your ARM
early to avoid payment increases,
many lenders will charge a penalty
fee for it.
Shopping for an Adjustable Rate
Mortgage
When shopping for a mortgage, it's important to compare the rates and terms
offered by different lenders. It's like anything else in life -- only by shopping
around can you find the best deal. These days, comparing one adjustable rate
mortgage to another can be confusing. That's because you have to understand
the concepts of index, margin, caps, payment options, etc. It is beyond the
scope of this article to show comparison examples, data charts, etc. But you
can get plenty of those from the Federal Reserve's tutorial on ARM loans, available
through the link below:
http://www.federalreserve.gov/pubs/arms/arms_english.htm
Primary Advantage of an ARM Loan
The biggest advantage of an adjustable rate mortgage is the lower initial interest
rate. Most lenders charge lower initial rates for an ARM loan than they charge
for fixed rate mortgages. And since the interest rate is a key ingredient
of the mortgage payment, this would in turn lower the mortgage amount you
have to pay each month. For many first-time home buyers, this can be a big
selling point for the adjustable rate mortgage. But there is also a key disadvantage
to these loans.
Primary Disadvantage of an ARM
Loan
As we have discussed, the characteristic that makes an adjustable rate mortgage
unique is that the interest rate adjusts periodically. When and how often the
loan adjusts is something you will know in advance, because the lender is required
by law to tell you those things. But the amount it adjusts will remain an unknown
variable, because nobody can predict what interest rates will do in the future.
This is the primary disadvantage of an adjustable rate mortgage, the uncertainty
of interest rate changes / increases.
Key Ingredients of the Adjustable
Rate Mortgage
To get an even better understanding of how the ARM loan works, you should understand
the key ingredients of such a loan.
* Initial Rate - We have
already discussed how an adjustable
rate mortgage loan starts off with
a relatively low interest rate in
the beginning. This is known as the
initial rate, and it will stay in
place for a limited period of time
-- usually 1 to 5 years. But here's
the thing to remember. On most adjustable
rate mortgages, the initial interest
rate (and by extension the initial
payment amount) can vary greatly
from the rates and payments you would
face later in the loan's term.
* Adjustment Period - This
is just what it sounds like, the
period during which your adjustable
rate mortgage adjusts to a new interest
rate (and payment amount). Usually,
the interest rate on an ARM loan
will change every month, quarter,
year, 3 years, or 5 years, with the
latter options being the most common.
A loan with an adjustment period
of 1 year is called a 1-year ARM,
which means the interest rate and
payment can change once per year
(after the initial period).
* Loan Descriptions - The
law requires that mortgage lenders
must give you written information
on each type of ARM loan you are
interested in. The information they
provide must explain the term / conditions
for each adjustable rate mortgage,
as well as details about the index
and margin (which determine the interest
rate), how your rate will be determined,
how often the rate will change, caps
(or limits) on rate changes, plus
an example of how high your monthly
mortgage payment might go based on
adjustments.
* Interest Rate Caps -
Interest-rate caps are an important
concept in the world of adjustable
rate mortgage loans. A cap is just
what it sounds like ... a limit on
the amount your interest rate can
increase. Interest rate caps come
in two versions: 1. Periodic adjustment
caps limit how much the interest
rate can go up or down from one adjustment
to the next (after the first adjustment).
2. Lifetime caps limit the interest-rate
increase over the life of the loan.
Lifetime caps are required by law,
so you'll find them on nearly all
adjustable rate mortgage loans.
* Payment Caps - Many ARM
loans also cap (or limit) the amount
your monthly payment can increase
at the time of each adjustment. So
if your adjustable rate mortgage
loan had a payment cap of 8%, your
monthly payment would not increase
more than 8% over your previous payment
amount. Be Careful Choosing an ARM
Loan
Avoiding Payment Shock
In your financial planning, the biggest thing you want to avoid is payment
shock. Payment shock is what happens when your mortgage payment rises steeply
during a rate adjustment. For example, let's say you took out an adjustable
rate mortgage for a $200,000 loan. During the first year of an ARM, you'll
usually enjoy a very low interest rate. That's the primary benefit. So let's
say you start out with a 4% interest rate that later goes up to a 7% interest
rate (after the second year). During the first two years, the mortgage payments
would be somewhere in the neighborhood of $950 per month. But after the adjustment
at year two, those payments would go up to more than $1,300. That's a big
difference.
Percentage points may not seem like
much by themselves. But when you
plug them into a mortgage calculator,
you can see how significant they
really are. So if you are considering
an adjustable rate mortgage, just
be wise about it and think long-term.
If you plan to stay in the home and
hold the loan for many years, make
sure you have a plan for when the
rate adjusts. Or make sure you can
handle a significantly larger mortgage
payment.
Conclusion
Here's what we want you to take away from this lesson. Adjustable rate mortgages
offer benefits up front (during the initial period) in the form of lower
interest rates. But they are full of uncertainty later on, and this can lead
to unpleasant financial surprises. If you understand this concept, and you
plan to sell the home a few years down the road, an ARM loan might be a good
option for you.
But if you're not comfortable with
the uncertainty of rate and payment
adjustments, or if you plan to stay
in the home (and hold the mortgage)
for many years, an ARM loan might
be a bad idea.
About the Author: Brandon
Cornett publishes a website full
of home
refinancing advice as well as
several other websites for consumers.
Visit the author online at http://www.mortgage-refinance-advice.com/blog/