“Get away from me you evil monster” is the look I get when I start explaining Adjustable Rate Mortgages. For the record ARM’s got a bad rap and aren’t all bad—they aren’t for everyone either so we need to evaluate a buyers needs and goals before making any recommendations.
Loans have either a fixed rate or an adjustable rate. Fixed rates provided a constant and steady payment over the life of the loan and adjustable rates can fluctuate with market conditions
Adjustable Rate Mortgages
Since the “Mortgage Meltdown”, Adjustable Rate Mortgages (ARMs) have been less common because many borrowers desire a payment that is fixed for the life of the loan. While a fixed rate is the safest option, ARMs offer a flexibility for the right borrower which can be the difference in getting the home they want. The biggest advantage an ARM offers is a lower payment and less interest paid initially. If a borrower has a plan in place and can benefit from the reduced payment, an ARM may be worth considering.
ARMs will typically have a payment that changes over time and even if a plan is in place to get out of the loan before it begins to adjust, a borrower should know the consequences if that doesn’t happen. It is critical that a borrower know the limits of change and how/when a rate change happens.
An adjustable rate is made by adding together 2 components called a Margin and an Index. The Margin will remain the same for the life of the loan, but the index will adjust based on economic factors. An ARM can only be associated with 1 index and it must be a published and recognized economic factor.
Most ARMs will have a fixed payment for a specific period of time and then can adjust periodically based on the index. The fixed period could be from 1 month to 10 years and, typically, the longer the rate is fixed, the higher the rate will be. A common ARM is a “5/1 Arm”. It is fixed for the first five years and then can adjust 1 time each year thereafter.
Caps are put in place to protect the borrower from rates varying uncontrollably and most ARMs have 3 caps: one at the first adjustment after the fixed period; one at each subsequent adjustment; and one for the maximum rate allowed at any time during the loan.
ARM’s have complexity to them and should be thoroughly investigated before agreed upon. Typical questions to ask would be: What is my starting rate? How long will that be in place? How much can it adjust the first time? How much can it adjust thereafter? What is the index it is tied to and can you provide a historical performance of that index?
By asking the right questions and investigating this option, a borrower can determine if an Adjustable Rate Mortgage is the solution to their needs.