Removing the Mystery from … Adjustable Rate Mortgages (ARM)
What is the difference between a fixed rate and an ARM?
A fixed rate mortgage is very straightforward. As the name suggests, your interest rate will never change over the life of your loan.
An Adjustable Rate Mortgage or “ARM” on the other hand, will carry an interest rate that can change from the initial or start rate and it’s important to understand how your rate can change and the potential impact that it can have on your rate. First, some important terms to know on an ARM are: start rate, change date, index, margin, and caps.
Your start rate will remain fixed for some period of time, from one month to ten years, depending on the program. At your change date at the end of this initial period, your interest rate may adjust based on its index and margin. The index is some changing but published rate that is often listed in the financial section of your newspaper. Typical indices are the US Treasury, COFI, and LIBOR. The margin is a fixed number established when you lock your rate which, when added to your index, gives you your new interest rate.
For example, suppose that your start rate is 5% and your change date is one year. Your rate will remain fixed at 5% for one year. Now assume that one year has elapsed and your index is 3%. You would add your fixed margin of, let’s say, 2.75% to your index to arrive at 5.75% for your new rate. Each year, your index may go either up or down, which determines what your new rate will be.
What is a teaser rate?
If the start rate for your ARM is actually less than the current index plus margin, than you have a “teaser” rate. In other words, if your rate were to adjust one day after you closed (don’t worry - this would never happen), and the new rate was higher than your start rate, then your start rate would be considered a teaser rate. There is no way to know whether your new rate at your first adjustment period will be higher or lower than your start rate, but the probability of your rate increasing is higher if you started with a teaser rate. It is common today for ARMs to have a teaser rate.
How high can my ARM rate go?
Your rate is limited by your rate caps. A rate cap limits how much your rate can adjust at your change date, and also limits how much your rate can change over the life of the loan. For instance, a cap of 2/6 means that your rate cannot change by more than 2% for any one adjustment, and cannot change by more than 6% over the life of the loan. Using the 5% start rate as an example, your first new rate cannot be less than 3%, nor more than 7%. And your rate can never exceed 11%.
What is a hybrid ARM?
A “hybrid” ARM or “Fixed Interim Rate Mortgage” (FIRM) as they are sometimes called is an ARM that usually remains fixed for a longer term than one year, usually three, five, seven, or ten years. This gives you the more attractive rate of an ARM, but the greater security of a fixed interest rate, at least for a few years.
An example of this type of ARM is a “5/1” which means that the rate is fixed for five years, and then may adjust annually (the “1” in 5/1) after the initial five years. The rate cap is often shown as something like “5/2/6”. The 5 refers to the maximum adjustment at the first change date (the beginning of year six in this example). The 2 indicates the maximum adjustment for each subsequent year (year 7, year 8, year 9, etc…) and the 6 refers to the maximum adjustment over the life of the loan. For example, if your start rate is 4.5%, it could potentially increase to 9.5% in year six, but could only increase or decrease a maximum of 2% in any subsequent year and could never exceed 10.5% over the life of the loan.
Why would I want an ARM?
There are several reasons why an ARM may be attractive relative to a fixed rate.
First, an ARM rate is usually less than a fixed rate. Obviously this is a good thing (at least for a while), but an additional advantage is that you can often qualify for a larger loan since many programs will allow you to qualify at your start rate which means that you’ll qualify for a larger loan amount.
One of the best reasons to choose an ARM is that you may expect to retire your loan within a short time period. For instance, let’s say that you have a 5/1 hybrid ARM. If you expect to pay off your loan within five years (by either refinancing, paying off your loan with cash, or selling your property) then it is an absolute no-brainer – the 5/1 makes sense for you. But what many people don’t realize (and neither do many loan officers) is that this loan may still make sense even you keep it for seven years or more. I like to use a “cash bucket” for this example.
Let’s say that you use your cash bucket to place the savings that you realize in with an ARM at 5% as opposed to a fixed rate at 6%. After the first year, you put your 1% of savings into this bucket. In year two (assuming a 5/1) you again toss your savings for that year into this bucket and so on through the first five years. In year six, lets assume that your rate increases by a worst-case maximum of 2% (assuming 2/2/6 caps) to 7%. Now, your new rate is a little higher than the fixed rate that you could have had at 6%, so you have to remove some of the cash from your bucket – but there is still a lot of cash left! In year seven, your new rate can adjust to a worst-case 9%. Better remove more cash from the bucket but, guess what, you’ll probably find that there is still some cash left! It isn’t until year eight when your rate might adjust to a worst-case 11% that you will peer into the bucket and find it empty, and have to look elsewhere for some more cash to make your payment. But look at what has happened. Your 5/1 ARM worked for you for more than seven years (and maybe much longer if rates actually drop)!
If you aren’t sure how long you will have your ARM, then this product may not be for you. However, keep in mind that the average person keeps his/her loan for 4-7 years and rates may actually go down on your ARM. In fact, ARMS became popular in the high interest rate environment in the early 80’s when borrowers figured that rates in the high teens couldn’t go much higher and were likely to come down.
As a final note, sometimes borrowers will flock to ARMS even in a low interest rate environment if rates start to show signs of increasing, because they want what they “could have had” with a fixed rate. But this thinking may not be rational. When rates are increasing, that may be exactly the wrong time to get an ARM.
Summary
The decision on whether to go with a fixed rate or an ARM can be difficult, and guessing wrong either way can cost you a great deal of money. If you choose an ARM, be absolutely certain that you understand how it works and what the worst-case scenarios are for you. This may be a decision that demands the input of a knowledgeable mortgage professional. At Apple Street Mortgage, we’ll happily help you visit the pros and cons of choosing a fixed rate versus all of the different ARM products available.