Facts about Adjustable Rate Mortgages
An adjustable rate mortgage, called an ARM for short, is a mortgage with an interest rate that is tied to a financial index rate set by the marketplace, and your payment will move up and down as interest rates adjusts rates up or down. The interest rate and your payments are periodically adjusted up or down as the index changes. It’s obvious that if rates go down, that’s good for you. In addition, you often get a lower starting rate because you’re sharing interest rate risk with the lender. However, if rates rise, that’s not good. There is an element of risk in adjustable rate mortgages.
An index is an interest rate that lenders use to determine interest rate changes on your mortgage loan. As the indexed rate moves up or down, so does the rate on your loan. Common indexes used by lenders include rates for short or mid term Treasury securities, but there are other indexes such as the cost of funds index, the LIBOR rate, and the prime rate. The index your mortgage uses is a technicality to determine the fully indexed mortgage rate, but it can affect how your payments change.
The margin on the loan is the lender’s markup. It is an interest rate that represents the lender’s cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. The margin will always stay the same during the life of a loan even if the overall rate adjusts down or up. It is the index that adjusts, not the margin. When comparing mortgage lenders, you must consider both the index and the margin rate being offered.
The adjustment period is the period between potential interest rate adjustments. You may see an ARM described with adjustment periods yearly. In this case loan during the first year your interest rate will stay the same as it was on the day you signed your loan papers. After that period the interest rate will adjust to the index rate at that time plus the margin. This number is the fully indexed rate and will be the basis for the mortgage payment until the next adjustment cycle. This example was as ARM with an annual adjustment–meaning adjustments could happen every year. Some ARMs adjust more frequently, or adjust sooner, or later.
Some adjustable rate loans have features that protect you against sudden or large shifts in rates. They do this by placing a cap on the total number of percentage points that the rate can rise. Caps are broken down into adjustment period caps and annual caps. The adjustment period cap limits the amount the rate can rise above the starting rate by a predetermined limit at the anniversary of the adjustment period. The lifetime interest rate cap will place a ceiling on the highest rate change the interest rate can be over the life of the home loan.
If payments can go up, why should you consider an ARM? You might qualify for a larger loan with an ARM. The initial interest rate for an ARM is lower than that of a fixed rate mortgage, where the interest rate remains the same during the life of the loan. A lower rate means lower payments, which might help you qualify for a larger mortgage loan. Also, you may not plan to remain in your house more than a few years. If you like to move frequently or must move frequently because of your job, you may benefit from the initial lower rate of an adjustable rate loan. The possibility of mortgage rate increases isn’t much of a factor if you plan to sell the home within a few years.
You also may have a reasonable expectation of increases in your personal income. Or, you may anticipate adding an income to your home through marriage, or a younger or older relative with an income. You don’t want to bet on increases in household income, but you can consider it if you really believe it will happen.
Some ARMs have a convertible feature that allows the loan to be converted to a fixed-rate mortgage. However, they have conversion requirements and the mortgage rate to which the loan will convert is dependent on the market at that time which may take away the savings you realized with the initial lower mortgage rate.
Payment caps are confusing feature found in a select category of ARMs. Payment caps limit how much your monthly mortgage payment can change during an adjustment period. The confusion many customers have experienced is that the payment cap does not stop the interest rate from changing. In a situation in which the rate goes above the amount used for the payment cap, negative amortization will begin. Negative amortization occurs when an ARM has a payment cap that keeps monthly payments from covering the cost of interest. The unpaid amount is added back to the home loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the home loan. Negative amortization is one of the really bad things that can happen with ARMs in rare circumstances. This is a situation to avoid if possible, unless you fully understand the risk s involved.
If you consider an adjustable rate mortgage, know how changes in the interest rate will change your payment. It’s one thing to acknowledge that the payment will go up, but it’s entirely another thing to see what the actual payment will be, especially if it falls outside of your budget. As always, don’t hesitate to ask as many questions as it takes to help you understand every aspect of ARMs and other home loans that are offered to you. Mortgage lenders are required to give you written information to help you compare and select a mortgage loan, but additional discussion is almost always required.