So you’ve dipped your toes into the scary water that is mortgage intricacies. It wasn’t that bad was it? Sure it’s a little scary at first, but you’ve started to realize that the water is that cold and murky; you might just be able to dive in head first and start swimming. I mean, heck, you read last week’s post about fixed-rate mortgages, you’re practically a pro at this point right?
Well I’m sorry; the pool of mortgage variables goes far deeper than you think and you’ve only just learned how to tread water. Don’t fret though! I’m here to throw you a life preserver and resuscitate your mind if you’ve drowned from the onslaught of mortgage jargon. In the continuing series of Know Your Mortgage, we tackle the slippery issue of adjustable rate mortgages.
Enough with the water and swimming metaphors; what’s an adjustable rate mortgage?
Well excuse me for getting descriptive. An adjustable rate mortgage, or ARM, is the main alternative (but still one of many) to a fixed rate mortgage. Where a fixed rate mortgage is, well, fixed, an adjustable rate mortgage is, you know, adjustable.
I’m listening, go on…
As mentioned last week, a fixed-rate loan is appealing for people who plan on staying at their house for a long time, which is why fixed-rate mortgages often go for 15 or 30 years. They have the benefit of consistent and steady payments, but they’re more expensive than ARMs
You’re right; I’m talking around the issue. For a more direct explanation of what an ARM is and what makes it work, listen to an expert on the topic, Bill Banfield.
He’s the Director of Capital Markets at Quicken Loans. Just read:
“An adjustable rate mortgage (ARM) has a lower interest rate than a 30Y Fixed mortgage. Because the initial interest rate is lower, your payments will be lower. ARMs come with an initial fixed rate period where the rate will not change and protection during the time when the rate can adjust to avoid any sudden spikes. Most ARMs are fixed for five or seven years. If, for example, you thought you were going to move in 5 years, you might select one of these ARMs and avoid the higher rate that comes with the protection of a 30Y Fixed.”
Ahhh! Break it down for me!
Calm down, I got you. The first sentence simplifies what I was trying to say earlier: ARMs have lower interest rates and are less expensive. The rest of the paragraph explains the brief lifespan of an ARM loan. You don’t plan on staying at your house for too long, so you get a 5 year ARM. Those first five years are still at a fixed rate so you’re not hung out to dry if there’s a crazy change in the interest rates that drive the prices.
Alright, so what happens after that?
Your interest rates will rise and fall based on a pre-selected index, and the index is typically LIBOR (London Interbank Offered Rate.) LIBOR’s rates are based off of the rise and fall of interbank rates, so your monthly payment will be tied to that.
What if the rates go up crazy fast all of a sudden?
Again, that’s the main consideration you have to make before agreeing to go on with an ARM. Just like the drawback for a fixed-rate mortgage is higher monthly payments for consistency, ARMs have lower monthly payments that can fluctuate. But don’t stress it too much; ARMs have a cap that sets a lock on how much your monthly payment can change per month.
Yes, it all depends on the arrangement you have with your ARM and mortgage company. But I’ll use example from the Quicken Loans Mortgage Glossary for some reference: “if your per-period cap is 1% and your current rate is 7%, then your newly adjusted rate must fall between 6% and 8% regardless of actual changes in the index.” So even if rates jumped or lowered to comical amounts, your monthly payment wouldn’t be yanked around too far with it.
That’s the know-how for all things ARM related, and about as simplified as I can put it without making all of our heads hurt. If you have any burning questions, feel free to ask below and stay tuned for more easy mortgage lessons as the weeks go on.