Most people have lots of questions about adjustable rate mortgages (and little bit of fear). Rightfully so. But before we discuss the specifics on an adjustable-rate mortgage (ARM), let’s first discuss fixed-rate mortgages.
Fixed-rate mortgage (FRM)
A fixed-rate mortgage (FRM) is a mortgage with an interest rate that remains the same over the entire term of the mortgage, regardless of how interest rates change in the marketplace.
- Finance their home when rates are relatively low.
- Want the predictable principal and interest payments over the long term.
- Seek protection from rising rates and monthly principal and interest payments.
What are the drawbacks?
- Generally, the interest rate is higher than the initial rate of an ARM.
- If the interest rates in the marketplace decrease, your rate will not adjust to a lower rate unless you refinance to a new mortgage.
So now let’s look at an ARM.
Adjustable-rate mortgages (ARM)
An adjustable-rate mortgage is a mortgage with an interest rate that is fixed for a specific period of time then changes at scheduled dates to reflect market conditions.
The initial interest rate is usually lower than on a fixed-rate mortgage, making your initial payments lower too.
The interest rate is based on a market index that is subject to change plus a margin that does not change.
Market index: A published rate, such as the prime rate, LIBOR, T-Bill rate, etc.
Margin: The set percentage the lender adds to the index rate to determine the interest rate of an ARM.
The initial interest rate is the total of these two values plus or minus small adjustments made by the lender due to market conditions.
When the initial interest rate adjusts, and at each subsequent adjustment, the interest rate will be the total of the market index and the margin, subject to any increase or decrease limitations, often referred to as rate caps or floors.
After the initial interest period, the interest rate can adjust up or down at regular intervals based on changes to the market index.
The following are descriptions of when the interest rate may adjust for different ARM products:
- A 6-month ARM adjusts up or down every six months.
- A 1/1 ARM adjusts up or down for the first time after 1 year, then every year after that.
- A 3/1 ARM adjusts for the first time after 3 years, then every year after that.
- A 5/1 ARM adjusts for the first time after 5 years, then every year after that.
- Will move and/or sell their home before the first interest rate adjustment.
- Want the ability to pay a lower monthly mortgage payment during their first year(s) of homeownership.
- Finance their home when fixed rates are comparatively high.
- Have sufficient income to manage a potentially increasing payment if refinancing or sale is not an option.
- Are willing to take a chance that their rate will stay the same or decrease when it adjusts.
What are the drawbacks?
If your interest rate increases at adjustment, you may experience “payment shock” if your monthly payments increase to an amount you may be able to maintain along with your other monthly obligations. Yikes!
If refinancing or selling is not an option, you could be at risk of losing your home. So be realistic and take caution when considering an ARM.