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Understanding Adjustable Rate Mortgages: ARM Basics

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Published on November 19, 2019
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Mortgage interest rates are currently pretty low. According to Freddie Mac, the average interest rate on a 30-year fixed mortgage is down well over a full point since November 2018. However, just as what goes up must come down, there’s also a floor to how far things will fall.

As interest rates start to go back up, taking advantage of an adjustable rate mortgage (ARM) can make sense, because yields on adjustable rates don’t rise as fast as those for fixed-rate mortgages. Because of this, the initial rate for an ARM is lower than you would see on a fixed mortgage for the same term.

However, while most consumers responsibly carry an ARM, there have been situations where the ARM didn’t make financial sense, and as a result, the loan earned a tarnished reputation. The vast majority of ARMs no longer involve the interest-only loans and optional payment plans that have distracted from the true nature of the loan option.

ARMs typically have 30-year terms. The rate remains fixed for a period of time – typically 5, 7 or 10 years. At the end of the fixed-rate period, the rate adjusts once per year up or down based on current rates. You get a lower initial rate with an adjustable mortgage than you would on a comparable fixed loan because you’re not paying for 15 or 30 years of rate security.

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. As rates rise, the spread between fixed and adjustable rates widens. For this reason, it can make a lot of sense to take an ARM as rates go up. Here’s information about ARMs, how to interpret the lingo and how to decide if it’s right for you.

Adjustable Rates 101

To comprehend the functionality of ARMs, there are a few terms to understand when talking to your mortgage banker to determine if this loan program is a good match for your financial situation:

Index: This is economic indicator used to calculate interest rate adjustments for ARMs. The index rate can increase or decrease at any time. As of this writing, the two most commonly used indexes are the London Interbank offered rate (LIBOR) for conventional loans and the Constant Maturity Treasury (CMT) for loans backed by the U.S. government.

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.

It would also help to be familiar with 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 5 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 2% the year after the fixed period expires. The second two means that the rate can change 2% 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 3.75% (4.456% APR) would be1:

Years Loan Amount Rate Principal & Interest Payment
1-5 (initial loan) $200,000 3.75% $926.23 per month
6 (resets 2% higher) $180,154.63 5.75% $1,133.36 per month
7 (resets 2% higher) $176,826.35 7.75% $1,354.06 per month
8 (rate increase 1% to 5% lifetime cap) $174,189.34 8.75% $1,467.74 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's still cost-effective. It’s also worth mentioning that for the fixed period of the loan, the ARM gives you the opportunity to save thousands of dollars (money you would have spent on the fixed-rate loan). This could give you the opportunity to do a number of things.

You have the ability to use the savings from the adjustable rate payment and put them toward other debts or your retirement fund. You might even choose to put the savings directly back toward the principal, enabling you to pay less interest over time.

Consider The Future

When looking at your loan options, you should definitely consider your future plans. In many cases, it may make more sense from a cost standpoint to take an ARM.

The reason for this is that you may well be moving by the time the ARM finally adjusts. According to the National Association of REALTORS® Profile of Home Buyers and Sellers for 2016, the average tenure in the home is 10 years. Historically, people spend 7 years in their home. If you know this probably won’t be your last home, you could take a look at a 7- or 10-year ARM. You would experience all of the benefits of the lower rate and you could very well be ready to move out before the rate ever adjusts.

If you think an adjustable rate could be right for you, you can check your options to buy or refinance today. You can get started online with Rocket Mortgage® by Quicken Loans® or give us a call at (800) 785-4788.

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1The initial payment on a 30-year $200,000 5-year Adjustable-Rate Loan at 3.75% and 74.91% loan-to-value (LTV) is $926.24 with 3.375 points due at closing. The Annual Percentage Rate (APR) is 4.456%. After the initial 5 years, the principal and interest payment is $975.97. The fully indexed rate of 4.25% is in effect for the remaining 25 years and can change once every year for the remaining life of the loan. Payment does not include taxes and insurance premiums. The actual payment amount will be greater. Rate is variable and subject to change after 5 years. The rate is current as of November 8, 2019.