With interest rates on fixed-rate mortgages trending upward, adjustable rate mortgages (ARMs) can be an attractive alternative. Several times over the last 30 years, consumers have turned to ARMs in market conditions that favored short-term rates over the traditional 30-year fixed.
However, while most consumers responsibly carry an ARM, there have been situations where the ARM did not make financial sense, and as a result, the loan earned a tarnished reputation. News of negative amortization loans and optional payment plans overshadowed the true function of the ARM which involves neither.
The truth is, many consumers have benefitted from ARMs and prefer to use them as a tool to save money in the short-term while planning for the long-term. Current market conditions are once again leaning in favor of adjustable rate mortgages and it’s important to understand their function. Here’s information about ARMs, how to interpret the “lingo” and how to decide if it’s right for you.
Adjustable Rate Mortgage Definition
An adjustable rate mortgage is a home loan with an interest rate that adjusts on a predetermined basis. Most ARMs begin with a fixed rate for a certain period of time and then adjust up or down according to the index on which it is based, after the fixed period expires. For example, if you have a 5/1 ARM, the interest rate is fixed for the first five years and then the rate adjusts once each year beginning in year 6.
ARMs typically offer a lower initial interest rate than a traditional 30-year fixed mortgage. After the fixed period, the interest rate can fluctuate based on market conditions but the loan agreement typically has a lifetime cap so the monthly payments cannot exceed a specific threshold. When interest rates increase, typically, loan payments also increase and the same is true when rates go down. However, each time the rate resets, it does so on the remaining years and the remaining balance of your loan, not the initial loan amount, which can help mitigate an extreme disparity between the previous payment and the new one.
Adjustable Rate Mortgages
To comprehend the functionality of ARMs, there are a few terms you should understand when talking to your mortgage banker to determine if this loan program is a good match for your financial situation:
Index: The economic indicator used to calculate interest-rate adjustments for ARMs. The index rate can increase or decrease at any time.
Initial Cap: This cap is the maximum amount the interest rate can adjust after the fixed-period. (The initial cap and the periodic cap may be the same or different i.e. 2/2/5 or 5/2/5)
Periodic Cap: This cap puts a limit on the interest-rate increase from one adjustment period to the next.
Lifetime Cap: This cap puts a limit on the interest-rate increase over the life of the loan. All adjustable-rate mortgages have an overall cap.
Adjustable Rate Mortgage Loans
You should also be able to recognize these terms in their numerical form, as this is the way in which your lender will illustrate the type of ARM you qualify for.
5/1: The five represents the amount of years the interest rate is fixed. The one indicates that the interest rate will adjust yearly after the fixed period.
2/2/5: (Note: Caps can be different depending on the term of the loan. For example, you may find that a 7-year ARM has a 5/2/5 cap structure). But for this example, the first two means that the most a rate can change is two percent the year after the fixed period expires. The second two means that the rate can change two percent every year thereafter, and the five means the maximum percentage that can be added to the initial rate for the lifetime of the loan.
For example, the maximum rate and payment you would experience for a $200,000 5/1 loan (2/2/5) at 3.99% would be:
|Years||Loan Amount||Rate||Principal & Interest Payment|
|1-5 (initial loan)||$200,00||3.99%||$953 per month|
|6 (resets 2% higher)||$177,136||5.99%||$1,140 per month|
|7 (resets 2% higher)||$173,978||7.99%||$1,359 per month|
|8 (rate increase 1% more because 5% is the lifetime cap)||$171,474||8.99%||$1,472 per month|
It’s important to note that while interest rates can rise, they can also decrease, making your payments smaller. The example above reflects the most you would pay if rates increased to the maximum or lifetime cap. Knowing the maximum amount you could end up paying on your ARM is important, because it will help you decide if it’s best to refinance prior to the expiration of the fixed rate, or continue to allow the rate to adjust because it is still cost-effective. Even with the adjusted rates, the average rate on this loan is 5.365%, which is comparable or lower than a 30-year fixed rate. In addition, the ARM gives you the opportunity to save thousands of dollars the first five years of the loan (money you would have spent on the fixed-rate loan) and gives you greater equity in your home because you reduce your principal faster. Being the financially savvy client that you are, you realize that the savings could be used to pay down additional debt, add to your retirement fund or something more creative!