Mortgage Savings Strategy: Adjustable Rate Mortgage (ARM)
Table of Contents
- What Is An Adjustable Rate Mortgage? (ARM)
- How Does An Adjustable Rate Mortgage Work?
- The 5/1 ARM
- What Are The Advantages Of An Adjustable Rate Mortgage (ARM)?
- Lower Initial Interest Rate
- Potentially Lower Interest Rates In The Future
- Interest-Rate Caps
- Why Is An Adjustable Rate Mortgage Bad?
- Interest Rates Could Increase
- ARMs Are Harder To Understand
- ARMs Are More Stressful
- Some ARMs Have Prepayment Penalties
- When Might An ARM Be Right For You?
- Remember, There Are Different ARM Options
- Interest-only ARM
- Payment-option ARM
- How Are Adjustable Rate Mortgage Interest Rates Calculated?
- Mortgage Savings Tip: Consider Getting An Adjustable Rate Mortgage (ARM)
- Have Questions About Adjustable Rates Or Other Mortgage Issues?
High-interest rates making buying a house unaffordable for you? Here’s a tip: consider getting an ARM – an Adjustable Rate Mortgage.
Here’s this mortgage savings strategy in a nutshell:
Consider getting an adjustable-rate mortgage instead of a fixed-rate mortgage.
- You can get them for a significantly lower interest rate (about a full interest rate point right now) than a traditional mortgage loan
- There’s the potential for your mortgage interest rate to actually drop if interest rates go back down in the future.
Sound interesting? Let’s start with an explanation of what they are and how they work.
What Is An Adjustable Rate Mortgage? (ARM)
Unlike classic fixed-rate mortgage loans that lock you into a fixed interest rate for 30 years, an ARM, short for adjustable-rate mortgage, is a loan where the interest rates vary based on the current interest rates in the market. This means that your house payment can go up or down.
Wow, that sounds scary, but the way they’re designed makes them lots less scary than you may think.
How Does An Adjustable Rate Mortgage Work?
Most adjustable-rate mortgages start off with your mortgage rate being fixed at a certain rate for a certain number of years. This is sometimes called a “teaser rate”.
This initial interest teaser rate is fixed for a certain number of years, for example 3, 5, 7, or 10 years (so don’t worry, you will be able to budget your mortgage payment for several years, just like you would with a standard mortgage.)
At the end of that time period, your interest rate will adjust to a different rate based on the current interest rates in the market. This means that your mortgage payment could go up or down. They then will remain fixed at that rate for a certain period of time, after which time they will recalculate again, based on current interest rates.
The time periods for each of these adjustments are reflected in the name of the ARM. For example, the 3/1 ARM, 5/1 ARM, 7/1 ARM, and the 10/1 ARM, with the first number being the initial teaser interest rate, and the second number being the number of years between interest rate adjustments after the teaser rate expires.
Just so you know, traditional adjustable-rate mortgages are sometimes referred to as a Hybrid ARM.
I’m sure that’s about as clear as mud, so let me give you an example.
The 5/1 ARM
Traditionally, the most popular adjustable-rate mortgage is the 5/1 ARM.
If you had a 5/1 ARM your initial interest rate would be constant for a full five years (60 house payments.) At the end of that period, your interest rate would adjust every year after that.
Hence the 5/1 name – 5 years fixed, 1 year between adjustments after that.
What Are The Advantages Of An Adjustable Rate Mortgage (ARM)?
Adjustable-rate mortgages come with both advantages and disadvantages.
Lower Initial Interest Rate
Periods of high and rising interest rates are very hard on mortgage lenders, so they respond by offering other options to help reduce peoples’ house payments. ARMs are one of those options.
Adjustable-rate mortgages are traditionally offered at a rate that is substantially lower than a traditional 30-year mortgage, sometimes a full percentage point or more. While that seems small, it adds up.
For example, if you were able to reduce your mortgage interest rate by 1 percentage point on a 30-year $250,000 mortgage, you would save just under $150/month in your house payment, or $1,800/year!
So, if your circumstances make an ARM the right choice (see below) you may want to consider this option!
Potentially Lower Interest Rates In The Future
One thing about ARMs – since each adjustment is tied to the current interest rate at the time it adjusts, your interest rate (and as a result, your house payment) could actually decrease in the future.
So, if you believe that the situations causing interest rates to be high right now are probably going to go away in the next few years, allowing interest rates to decrease to lower rates, an ARM might be right for you.
Now, it’s important to note that nothing’s guaranteed in the world of interest rates. They could also be higher when it comes time for your interest rates to adjust, so you should definitely keep that in mind.
Another feature of ARMs is that they come with caps that limit how much your interest rate can change from one adjustment to the next. These caps control
- How much interest rates can change from one period to the next (if you have a cap of 2% and the current interest rate is 3% higher, your interest rate will only increase by 2%).
- The maximum interest rate you can ever be charged, just in case really bad things happen and interest rates increase substantially and stay high for years.
You should ask your mortgage lender about the caps on the ARMs you are considering. They’re expressed as 3 numbers, for example, 2/2/5.
The first number is how much your interest rate could increase the first time your interest rate is adjusted.
The second number is how much it could increase on any subsequent adjustment.
And the third number is the maximum amount your interest rate could increase at any time during the life of your loan.
Why Is An Adjustable Rate Mortgage Bad?
Of course, there are disadvantages to ARMs too.
Interest Rates Could Increase
Even though ARM interest rates are controlled by caps, an increased interest rate could result in mortgage payments you simply can’t afford.
ARMs Are Harder To Understand
I’m sure you’ve seen, just from reading this article, that adjustable-rate mortgages are way more complex than a simple fixed-rate mortgage.
ARMs Are More Stressful
ARMs add to your stress level, wondering what your house payment will be in the future, and having to make changes to your budget and payment processes each time an adjustment occurs.
Some ARMs Have Prepayment Penalties
Most loans in today’s world have allowed you to pay extra towards reducing your principal without paying a penalty. Unfortunately, there are some ARMs that don’t allow you to do that. Check with your lender to make sure that’s not a factor in your loan.
When Might An ARM Be Right For You?
ARMs might be right for you (versus getting a fixed-rate mortgage instead) if:
- You don’t plan to stay in this home for more than a few years.
If you’re confident that, due to employment changes, a growing family, or other situations, you’ll be moving out of this house before the teaser interest rate expires, then you might as well get your mortgage at a discount!
- You are confident that interest rates will be falling in the next several years.
If you believe the reasons for the current high-interest rates will be corrected and rates will drop in the next several years, an ARM may be perfect for you. (Remember, you may be wrong!)
- You are willing to make extra payments on your loan.
When ARMs recalculate, they do so based on the amount you owe at that time. So, if you’re willing to pay extra towards your loan principal, your recalculated house payment will be lower than it would have been if you hadn’t.
Remember, There Are Different ARM Options
One of the advantages of ARMs is there are many different loan options available. Let’s say, for example, that you are confident interest rates will be going down in the future, but think that it may take longer than 3 years for that to happen. If that’s the case, you may want to consider a 5/1 or a 7/1 over a 3/1 ARM.
You may also want to consider:
When you have an interest-only ARM, you only pay interest on your loan for a set period of time (a few months to a few years,) after which your payments will increase to include both interest and principal on your loan. Obviously, during this initial payment period, you are not building equity in your home (unless the value of your home increases.) An interest-only loan may be a good option if you know your income will be increasing significantly in the future, and you’re looking to get into a house at an affordable rate now.
In a payment-option ARM, you are free to make adjustments to your payment amount (as long as it is bigger than a certain required payment), schedule, and even loan term to meet your financial needs. This is a much more complex loan, and it could result in what is called negative amortization, where your payments aren’t enough to cover your interest, so the amount you owe on your loan actually increases each month. Payment-option ARMs are not right for most people but could be an option for some.
Payment-0ption ARMs were one of the most defaulted on mortgages that led up to, and contributed to the great real state crash of 2008. It is unlikely that you will find a payment-option ARM in today’s market because they have been mostly discontinued.
How Are Adjustable Rate Mortgage Interest Rates Calculated?
Adjustable-rate mortgage rates, well, adjust. 🙂 So how are those adjusted rates determined?
Your mortgage contract will state three things that combine to dictate your adjusted interest rate.
- The index your rate will be tied to. These days that rate will most likely be the one-year US Treasury bill, but it could also be the 11th District cost of funds index (COFI), or the Secured Overnight Financing Rate (SOFI). The important thing is not to understand all that mumbo-jumbo, but to recognize that each of these numbers is one that is easily tracked, publicly available, and theoretically, hard to manipulate.
- The “lock date” that the index rate will be tied to.
- A margin rate will be added to that index rate to determine your new interest rate.
Mortgage Savings Tip: The margin rate varies by lender, so you may want to shop around to see if you can get a better margin rate.
Let’s say that your loan is tied to the one-year US Treasury Bill interest rate plus a margin of 3 percentage points. Your lender will look at the Treasury Bill interest rate on your interest rate lock date, add 3 percentage points to it, and that will be your new rate.
So, if on that date, the one-year Treasury Bill interest rate is 2.5 your new interest rate will be 2.5 + 3 = 5.5%. If the next year, it is 2.8, your new interest rate will be 2.8 + 3 = 5.8%.
But if the Treasury Bill rate jumped a lot, your interest rate caps may come into play, resulting in your paying the capped rate instead. Let’s imagine that you have a 2% cap, your previous interest rate was 5%, and the margin rate was still 3%, but this time the Treasury Bill interest rate increased to 5.5%.
In that case, without a cap, your new interest rate would be 5.5 + 3 = 8.5%.
But your cap would not allow your interest rate to increase by more than 2 points more than your old rate of 5%, so instead, your new rate would be 5 + 2 = 7% instead of the 8.5% it would be otherwise. That’s why caps are a good thing!
Mortgage Savings Tip: Consider Getting An Adjustable Rate Mortgage (ARM)
In conclusion, in times of rising and high-interest rates, adjustable-rate mortgages are usually available at a discount versus a standard fixed-rate mortgage and could be a good idea for you.
They’re riskier and more complicated, but could be the perfect solution for you.
Have Questions About Adjustable Rates Or Other Mortgage Issues?
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