Adjustable Rate Mortgage Basics
The pricing on all loan types varies widely with the economy. Sometimes adjustable mortgages make sense and sometimes they don’t! As of 2024-03-12 adjustable rate mortgages are more expensive than fixed rate so we strongly don’t recommend them.
What is an adjustable rate mortgage (ARM)?
Adjustable Rate Mortgages (ARMs) are simply loans that do not stay at a fixed interest rate for the life of the loan.
The rates will fluctuate in relation to an index such as the prime rate or the London Interbank Offered Rate (LIBOR). Here are some important concepts:
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Initial Interest Rate: ARMs often begin with an introductory interest rate that is typically lower than the prevailing fixed-rate mortgage rates. (That’s the whole point of why you would choose an adjustable mortgage. More on that later.) This initial rate is in effect for a specified period, usually ranging from 1-10 years.
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Adjustment Period: After the initial period, the interest rate on an ARM will adjust periodically. The frequency of these adjustments can vary but is commonly annual or semi-annual(6 months).
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Index: The interest rate adjustment is tied to a specific financial index, such as the Constant Maturity Treasury (CMT) index or the LIBOR. Changes in the index value directly impact the interest rate on the ARM.
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Margin: Lenders add a margin, a predetermined percentage, to the index rate to determine the new interest rate when adjustments occur. This margin is consistent throughout the loan term.
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Caps: To protect borrowers from extreme fluctuations in interest rates, ARMs often come with caps limiting how much the interest rate can increase or decrease during each adjustment period and over the life of the loan. Common types of caps include initial adjustment caps, periodic adjustment caps, and lifetime caps.
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Hybrid ARMs: Some ARMs have a hybrid structure, combining an initial fixed-rate period with subsequent adjustable-rate periods. For instance, a 5/1 ARM features a fixed rate for the first five years before converting to an adjustable rate for the remainder of the loan term.
The most common type of ARM offered is a Hybrid where you have a fixed lower initial rate for a few years.
This is so common that if you say “hybrid”, most loan officers won’t know what you’re talking about.
Why would I use an ARM?
Advantages:
- Lower initial rates = lower initial payments
Disadvantages:
- Uncertainty of future rates
- Risk of payment increases
- Budgeting challenges
Factors to Consider Before Choosing an ARM
- You future financial stability
- The market outlook
Future financial stability
Analyzing future financial stability before opting for an Adjustable Rate Mortgage (ARM) is crucial. Consider your current income stability, job security, and career prospects. Taking on an introductory payment that can increase beyond your comfort range could be risky.
Ensure that your income is stable and you can handle fluctations in both your mortgage and your own income.
The market outlook
At Kasey Home Loans we always like to be conservative and assume the market will stay the same or get worse.
When an Adjustable Rate Mortgage Might Be a Good Fit
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When the rate and costs are substantially lower than a fixed rate.
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You only plan on staying in the home for a shorter period of time and you meet item 1.
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- You have analyzed the cost of refinancing out of the ARM and you understand the risk that you might not be able to when the adjustment time comes.