Over the past several years, the popularity of adjustable rate mortgages (ARM’s) has sky rocketed as consumers have sought out ways to reduce their monthly mortgage payments to give them the flexibility to afford the higher prices of today’s homes. Unfortunately, many consumers took out ARM’s without fully understanding how they work and how this type of loan could impact them in the future.
By way of background on adjustable rate mortgages, there are two primary factors that determine the interest rate you are going to pay. These factors are the loan’s index and the loan’s margin. The index is the market rate that your loan will be based on and is available through third party published sources. There are a number of different indexes used with today’s ARM’s and they will have catchy acronyms like COFI, LIBOR and CMT. These indexes can either be based upon the average of the particular index rate or could be based on a spot rate (the rate as of a particular date). If your ARM index is based on an average rate of an index it will tend to adjust more slowly. Spot mortgage rates tend to much more volatile and can go up and down very quickly as they will be based on the rate as of a particular day.
The second factor impacting your interest rate is the margin on your loan. The margin is the additional interest percentage points that are added on top of the index to determine your loan’s interest rate. The higher your loan’s margin, the higher the rate that you will pay. A margin might be two to three percent above your index. If your index was five percent and your margin was three percent, your interest rate would be equal to eight percent.
Now that you understand how indexes and margin impact your loan’s interest rate, it is important to understand some other terms that are unique to an ARM loan. Two important elements of your ARM are the introductory rate and the reset period. The introductory rate, which is sometimes called the “teaser” rate, is the initial rate on your ARM. This introductory rate will stay in place until you reach your reset point, which is the first time in which your loan’s interest rate can have a rate adjustment. The rate adjustment will be described in your loan documents and will be based on the current level of your loan’s index and the margin on your loan. Often ARM’s will have terms like 3/1 or 5/1 ARM’s. This refers to the reset point (after year three for a three year ARM or year five for a five year ARM) and the index (the “1” usually refers to a one year treasury index or a LIBOR (London Interbank Offered Rate).
As you can see, these ARM’s are quite a bit more complicated that the traditional 15 year or 30 year fixed mortgage products. With these fixed options, you will have the same monthly payment throughout the term of the loan and a fixed amortization schedule. This allows you to know at any point of time during your loan’s life what your principal balance will be and how much interest expense you will pay. With ARM’s, there is no way to know your payments and your principal balance as you are subject to a changing index. Many ARM’s allow for the interest rate on a loan to jump significantly after the introductory rate period is over. As a borrower, you need to fully understand how much more your interest rate can be and what this change in the interest rate will do to your monthly payments. Many of the problems that you read about today relative to ARM borrowers having problems meeting their loan payments is the result of the borrowers not fully understanding how much their monthly payments could jump up with their first rate adjustment. Many borrowers took out mortgages between 2003-2005 when the U.S. was experiencing some of the lowest interest rates in the past 40 years.
Despite the complexities, ARM’s do have a lot of appeal for the savvy borrower. If you know you are only going to be in your home for a certain period of time, you can often save a lot of money with an ARM vs. a fixed mortgage. As an example, if you plan to stay in your home for less than five years, a 5/1 ARM might allow you to substantially reduce your out of pocket mortgage costs during the first 60 months of your loan over a fixed mortgage option. However, if you end up staying in your home beyond the 60 month period, you will need to understand the details on how your loan could adjust and what your monthly payments could be.
To help you navigate through these loan choices, you should seek out an experienced and qualified mortgage broker or mortgage banker. The right professional can provide you with a full range of loan options based on your financial situation, credit quality and the amount your will be borrowing. The key lesson is that before you sign your name of the loan documents for an ARM, make sure you fully understand how your loan works and what the adjustable features can mean for you and your financial situation.