Adjustable Rate Mortgage (ARM)
Not everybody needs thirty years or more of predictability from a mortgage. With an adjustable-rate mortgage (ARM), your interest rate fluctuates from year to year or at even shorter intervals depending on the specifics of your loan. This increases your risk given that no one can predict if interest rates in the future will be higher or lower than they are now. Lenders offers you a lower interest rate at the beginning of the loan in exchange for that risk. There are some very good reasons to take out an ARM. If you’re all but certain you will move within the next decade or refinance into another loan, why should you pay extra to lock down your mortgage payments another two decades beyond that point? It’s a waste of money. Alternately, if you’re in the early years of your career then you need to go for a cheap interest rate. Later, when you’re earning enough then you’ll probably be able to handle a higher interest rate as well. Many buyers who might prefer the predictability of a 30-year fixed-rate mortgage, especially when interest rates are rising, find then have to use an ARM because the lower payments it offers in the early years are all they can afford. Lenders base their qualification decisions on the payment level during the second year so keeping that payment as low as possible with an ARM will help you qualify if your are right on the edge.
So how do adjustable-rate mortgages work? Let’s look at the traditional choice in adjustables – the one-year ARM. Your rate is adjusted according to the specific “index” plus a “margin” or markup to arrive at your new rate each year. Most one-year ARMs are pegged to an index of one-year Treasury securities. The lender adds a margin of about 2.75 percentage points to arrive at the interest rate charged to the borrower to that index. Be sure to compare the margins when shopping for an ARM because that’s what really determines how expensive a loan is. But lenders usually sweeten the deal for the first year, offering an interest rate that is lower than the index plus margin would call for. Because of this ARM borrowers can usually expect a rate increase in the second year even if the company is not experiencing rising interest rates. Your risk is limited significantly by two crucial caps. One cap limits how much your rate can rise or fall from year to year. The other cap sets an absolute limit on the rate you can be charged at any time during the overall 15 to 30 year term of the loan. Most one-year ARMs carry interest-rate caps of 2 percentage points per year and 6 percentage points over the life of the loan. If you were to take out an arm with a 4 percent initial rate, the interest could go no higher than 6 percent after one year. The highest it could ever go would be 10 percent. Remember to always, always double-check that the caps are in this reasonable range before you sign the loan documents. This is especially important if you’ve had some credit problems and can only qualify for special, higher-interest loans designed for risky borrowers.
Beware of loans that cap the payment but not the interest rate. If rates rise quickly, your payment might not be enough to pay down your loan balance. This situation is called “negative amortization,” and it means you could face a big sum of interest that still needs to be paid off after your loan was scheduled to end. Insist on a loan that caps both your payment and the interest charged. You may encounter an ARM that adjusts every six months. While you would face rate adjustments twice a year, you should also have lower rate caps. Caps of 1 percentage point at each change and 6 percentage points over the life of the loan are typical. If the economy were to go through a period of rapidly rising interest rates, six-month ARM borrowers would feel the pinch faster. Of course they’d be the first ones to feel relief when rates decline as well.
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