Adjustable rate mortgages (ARM) can be intimidating for a borrower to think about when they are going through the mortgage process.  An ARM has its benefits and risks.  I always tell my clients, if you don’t like gambling, don’t go with the ARM.

ARMs have changed over the years.  Today if you were to get an ARM, it would be not be a pure adjusted rate, rather a hybrid ARM.  The borrower’s interest rate will start off lower with an ARM than a fixed rate.  For example, if a borrower was getting a fixed rate on a conventional loan today with a rate for 4.125, on an ARM they would be offered an adjustable rate of 3.25.

So why doesn’t everyone do it?  Its risky, the rates do adjust.  If a borrower is getting a 5/1 ARM then the rate of 3.25 would be locked in for 5 years, then it would adjust yearly.

What factors make it adjust?

There will be different factors that determine what your rate adjusts to.  First, there is the index, which will adjust based on which index the lender uses.  A popular one is the LIBOR index. The index value changes from month to month.  These index values can be found online or in the newspapers.

Another contributing factor is the margin.  The margin is a fixed percentage rate that is added to the index.  Make sure you know what the margin is prior to making the decision to get an ARM, so you know whether or not you will be comfortable with the payment.

Example time
Say your rate at the beginning of your ARM is still the 3.25.  LIBOR (your index) has a value of .90 on the day your loan adjusts.  Your margin is 2.25.  Your interest rate would be a 3.15%.  You would have made out and have been happy you gambled!

Interest Rate Caps

To help know what you, as a borrower, are getting into, lenders have interest rate caps.  These caps can serve to help you in the event that the market’s rates are on a high rise.  There are 3 different numbers.  The first, subsequent, and lifetime.  Lets use 2/2/5 as our example.

The first number, which is the highest that an interest rate can go during the first adjustment is 2.  So if our interest rate is 3.25 the highest it can go up the first adjustment is to 5.25, even if the index and margin calculate otherwise.

The second number, the subsequent adjustment, is 2.  This is the highest the rate can increase for every subsequent adjustment.  Say during your first adjustment your rate, your rate went from 3.25 to 4.25.  The highest your rate would be able to go during your second adjustment is 6.25.

The third number, which is 5, is the lifetime number.  This is the highest your interest rate can go up for the life of the loan.  So if your starting rate was 3.25, your interest rate could never exceed 8.25.

I hope this helps break down an adjustable-rate mortgage.  It is a great choice for some borrowers, who don’t plan to stay in their house for year to come, or plan to pay their mortgage off quickly (there are no pre-payment penalties).  It also might be a good option for a borrower when the rates are not doing well.

If you have any questions about an ARM or are wondering if it is right for you, please feel free to contact my team and I with any questions.