By definition, an Adjustable Rate Mortgage or ARM is a type of loan that features a changing interest rate. Whilst these loans might start with monthly payments that are lower than fixed rate mortgages, there are four important observations that you should take note of.
Firstly, the monthly payments can change – they can go up considerably even when interest rates haven’t gone up. The payments may not decrease by much, or at all, even when interest rates do go down. Third, even when you have made all your payments on time you could still end up owing more than you borrowed. Lastly, paying off your Adjustable Rate Mortgage early in an attempt to evade higher payments could see you pay a penalty.
Considerations for an Adjustable Rate Mortgage Loan
So as to accurately compare two ARMs, or to compare an Adjustable Mortgage Rate against a fixed rate mortgage, there is need to have some knowledge about what the various terms involved are including indexes, discounts, negative amortization, margins, caps on payments and rates, payment options and the recalculation or recasting of your loan. It is important to know how high your monthly payments can rise. It is also of great importance to know how your monthly ARM payments will be affected in terms of whether you will be able to maintain higher payments in the futurt
Four Guidelines Before Taking an ARM
An Adjustable Mortgage Rate loan is a trade-off whereby when you assume more risk over the long run you are given a lower initial rate. The following questions should help you make an informed decision:
- Is your income adequate, or likely to increase adequately, to enable you to take care of future higher mortgage rates in the event that interest rates rise?
- Will you be taking on other considerable debts, e.g., tuition or car loans, in the near future?
- For what length of time do you intend to own the house? Increasing interest rates might not pose a problem if you intend to sell the house soon but they might if you plan on holding on to the house for long.
- Do you plan on making any additional payments or paying off the loan early?
The following are the basic features of an Adjustable Rate Mortgage Loan:
The Initial Rate and Payment
The initial rate and amount of payment on an Adjustable Rate Mortgage loan only apply for a limited period of time which can be a month or even more than five years. The initial terms you receive can vary greatly compared to what the terms later on will be even when the interest rates remain as they were initially. It is prudent to ask lenders what the APR, i.e., annual percentage rate, is when they give you a quote of the ARM’s initial rate and amount of payment. If the APR is considerably higher than the initial rate, this should be your cue to know that the rates and payments will be much higher when your loan adjusts. This will apply even when the general interest rates have remained similar.
The Adjustment Period
For most ARMs, the change of interest rate and monthly payment takes place monthly, quarterly, annually, after 3 years, or after 5 years. The interval between rate changes is referred to as the adjustment period and this is what gives name to a particular Adjusted Rate Mortgage, e.g., an interval of three years makes for a 3-year ARM.
The interest rate for an Adjusted Rate Mortgage is composed of two parts – the index and the margin. The index is a general measure of the interest rates while the margin is the extra amount added on by the lender. Any caps and limits on the highs and lows your rates can reach will affect your payments. Increasing index rates will most likely result in higher interest rates and subsequently higher monthly payments, and vice versa. It is important to note that not every Adjusted Rate Mortgage adjusts downward and as such it is prudent to adequately research information about a specific ARM that you wish to take. The commonplace indexes in use are the COFI, i.e., Cost of Funds Index, the LIBOR, i.e., London Interbank Offered Rate, and the rates on 1-year CMT, i.e., constant-maturity Treasury securities.
The margin is added to the index rate so as to arrive at an ARM’s interest rate, i.e., the fully indexed rate. A discounted index rate implies that the loan’s initial rate is less than the fully indexed rate. A number of lenders base the margin amount on your credit record; the better it is, the lower your margin, and therefore the lower your mortgage interest. As you compare various Adjusted Rate Mortgages it is important to check out what the index and margins for the different ARMs are.
The amount to which your interest rate can rise is limited by an interest-rate cap; there are two types of this as follows:
- Periodic adjustment cap – this limits the interest rate adjustment up or down in successive adjustment periods following the first adjustment.
- A lifetime cap – this limits the increase of the interest-rate over the loan’s life and is a mandatory requirement for virtually all ARM types as required by law.
Many Adjusted Rate Mortgages cap or limit the amount your monthly payment may rise each time an adjustment is due. A payment cap of 5½% means that regardless of the rise of interest rates your monthly payment will not exceed more than 5½% above your previous payment.
Advantages of an Adjusted Rate Mortgage Loan
- You save on money – ARMs tend to have lower initial interest rates compared to fixed mortgages; borrowing such means that your payments will be cheaper before the ARM rate goes up higher than the fixed rate in the event that mortgage rates are rising.
- Rates are high presently – When rates are high, getting an ARM means that you have two advantages to enjoy. First, when interest rates start falling, your monthly payments will follow suit without you needing to refinance. Secondly, the time of your initial interest rate will be profitable given that this rate will be lower than that for comparable fixed rate mortgages.
- Assumability – More often than not, new buyers of property can assume the old owners’ ARMs. This is of great help should interest rates be high since the ARM will go down with the interest rates after they peak and start dropping.
- Refinancing is unnecessary for dropping rates – One doesn’t need to refinance since the monthly interest and overall payment will decrease at each scheduled revision.
Disadvantages of the Adjusted Mortgage Rate
- Negative amortization – An ARM has a cap on the monthly mortgage payment but not on the monthly interest rate. If this rate is increased by 1% monthly it means that 1% will be added to the ARM balance each month. As such the loan balance actually increases each time you pay your monthly mortgage payment.
- Teaser rate – This is another term for the initial interest rate. It doesn’t last for long before being replaced by a high interest rate and is therefore a poor means of evaluating a suitable ARM. This error is often the case for novice borrowers and it’s quite unfortunate -evaluations are best made using index and margin figures.