If you an inconsistent income or you want a lower payment for a few years on your mortgage, an ARM may be a good fit. Before you sign on the dotted line, you should know how they work. Adjustable rate mortgages work different than fixed rate loans. Your rate adjusts periodically. It is dependent on the index and margin. Knowing these terms and how the loan works will help you decide if the ARM is right for you.
How an Adjustable Rate Mortgage Works
First, let’s look at how an adjustable rate mortgage operates. It is different than its fixed rate counterpart. A fixed rate loan has the same payment for the life of the loan. The only time it may change is if you have escrowed taxes and insurance. For example, if your taxes increase, your mortgage payment changes. Your mortgage lender has no control over this.
An ARM, however, adjusts according to the predetermined factors. A few of these factors include:
- Index – This is an interest rate based on market conditions. It is a volatile rate that changes often. This is the basis of your new interest rate.
- Margin – This is a predetermined addition to the index. We discuss this in more detail below.
- Adjustment period – There are varying periods of adjustment. Many ARMs adjust annually after the initial fixed period. For example, a 3/1 ARM has a 3-year fixed period and then adjusts once per year.
Fortunately, ARMS have caps. These are maximum amounts the rates can change. Here we define each type of cap:
- Initial cap – This is the maximum amount your rate can adjust for the first adjustment. In our 3/1 example, the initial cap would cover the adjustment after the first 3 years.
- Subsequent cap – This is the cap that covers future adjustments. Many lenders maximize this cap at 2%. This means your rate can’t change more than 2% per year.
- Lifetime cap – This is the total amount your rate can change over the life the loan. Many lenders offer a 5% cap. This means your rate will never be 5% higher than the original rate.
As you can see, the ARM is more volatile. You can’t predict the adjusted rate for any period. It may go up and it may go down. You never know.
Looking Closer at the Index
Now, let’s look closer at the index. The most common choice is LIBOR. This is the London Inter-Bank Offer Rate. If you are curious about this rate, you can look it up online or in the Wall Street Journal to see its history.
The index your lender chooses is disclosed to you during the loan application process. Once it is chosen, it doesn’t change. The lender has no impact on this number.
Knowing what index the lender chooses works to your benefit. This way you can research its history. See how it performs and how your loan may be affected. Remember, it’s not the only factor in your adjusted rate, though. The margin plays a role too. We look at it below.
Looking Closer at the Margin
Something the lender does have control over is the margin. The lender chooses it. Once chosen, however, it doesn’t change. Because this number can vary from lender to lender, you should shop around. One lender may charge a 2% margin while another may charge 1.5%. That 0.5% could make a difference in your payment.
Comparing ARM Loans
Now that you know how ARM loans work, you can learn how to compare them. As discussed above, lenders choose their own margin. They also choose the rate caps, though. One lender may have a 2% subsequent cap while another has a 3% cap. This can make a large difference in your payment.
Don’t get caught up in the initial interest rate. This is how lenders make ARMs attractive. They show a low interest rate that beats any fixed rate. Borrowers that don’t understand the margin, index, and caps can find themselves in over their heads when the rate adjusts.
Look at each aspect of the loan. Compare them side-by-side. You can even ask the lender to calculate the maximum fully indexed rate for you. This way you know how high your payment may go. This allows you to determine if you can afford that loan. If you don’t want to take a chance on such a high payment, you may shop elsewhere.
A Real Example
Let’s look at a real example of an ARM loan in action:
A lender offers you an initial interest rate of 4% on a 3/1 ARM. The index is LIBOR. Your rate adjusts after the 3rd year. At the start of your 4th year, the LIBOR is 2.5%. Your margin is 3%. This means your 4th year rate equals:
2.5% + 3% = 5.5%
Of course, this depends on the caps the lender offers. Many lenders offer a 2% initial cap and a 2% subsequent cap. This means your initial rate couldn’t exceed 6%.
Every lender differs in their offerings for ARM loans. Pay close attention to the margin and index. Don’t forget the caps too, though. Understanding the terms of an adjustable rate mortgage can help you make the right decision.
We suggest comparing the ARM loan to a fixed-rate loan. Ask the lender for the maximum loan payment allowed on the ARM. This way you can compare it to the fixed rate loan. Determine how much you may save with the ARM. You should also consider how long you plan to stay in the home. Borrowers planning to move within a few years often benefit from the low ARM rate initially. Once it adjusts, you may have already sold the home.
Consider all the factors involved in an ARM loan. Talk to your lender and ask many questions about it. This way you can make the decision that is right for your situation. There are several ARM terms ranging from 3-10 years. The longer your fixed rate, the higher it becomes, but it offers a lower risk.