Adjustable Rate Mortgage – Universally known as ARMs – have cleaned up their image enough to once again be considered a useful product in the home-buying market.
An adjustable rate mortgage is a home loan whose interest rate and payments will change periodically, based on rising or falling of interest rates. Homebuyers gamble that the low-interest rate that ARMs typically offer at the start of the loan, won’t rise so quickly that they can no longer afford the home.
ARMs got a black eye in the real estate market crash of 2007, but the swelling has gone down enough that they represent 14% of the dollar volume on mortgage applications in 2018.
That’s a decent revival after crash landing at just 2.8% of the market in December of 2009. ARMs accounted for 49.7% of the market in their heyday back in 2005. They may never be that popular again, in part because interest rates are at historical lows, and because ARMs are complicated financial instruments to understand.
But their rebirth proves that people are reconsidering them, especially those who only expect to spend a short time in the house they are buying. Adjustable mortgages always have been attractive to first-time homebuyers and any consumer who expects to move or sell their home before the adjustable rate portion of the mortgage kicks in.
“There are two main benefits to an adjustable rate mortgage,” John H. Vogel, real estate professor at Dartmouth’s Tuck Business School said. “You get a lower interest rate meaning a lower monthly payment, and you may qualify for a larger loan based on the fact the lender can use your initial monthly payments to calculate your debt capacity.”
What is a Hybrid ARM?
Also contributing to the turnaround is the fact the lending industry is offering more palatable versions of the product to consumers. Today’s “hybrid ARMs” offer a break on interest and a fixed payment amount for the introductory period before reverting to adjustable rates at the 3, 5, 7 or 10-year mark.
Right now, that break doesn’t amount to much, given how low interest rates are for 15-and-30-year mortgages. But interest rates have risen steadily over the past year and are expected to continue rising, so the spread between a 30-year fixed rate mortgage and the first few years of an ARM may widen enough to make it even more appealing.
If you are just getting started in the workforce and homebuying market, every dollar counts and ARMs can save a few dollars, at least until the dreaded adjustment period kicks in.
Types of ARMs
The truth is, you might not even recognize today’s ARMs, especially if you were one of those who got sucked into an adjustable mortgage back in 2005. Back then, prepayment penalties and negative amortization (paying less than the minimum interest so the balance went up, not down) were “fine print” parts of ARMs and caused disastrous results for consumers.
The new version of ARMs is divided into three types:
- Hybrid ARMs. These offer a mix of fixed-rate and adjustable rate financing. You will see them labeled 3/1, 5/1, 7/1 and 10/1 loans. The first number stands for how many years you will pay a fixed interest rate before the adjustable rate kicks in. The second number stands for how often that rate will change after the fixed-rate period ends. So, for example, a 5/1 ARM means you will pay a fixed rate interest for five years, then an adjustable rate every year after that until the loan is paid off.
- Interest only ARMs. With this option, you pay only the interest for a specified time, after which you start paying both principal and interest. The interest-only (I-O) period usually is somewhere between three and 10 years. The interest rate will adjust during both the interest only period and interest + principal period. The I-O payments obviously are significantly less than principal + interest payments. When that rate kicks in, your payments will go up dramatically.
- Payment-option ARMs. This ARM allows you to choose between three options every month. You could choose to make traditional principal and interest payments; or interest-only payments; or a limited payment that may be less than the interest due that month, thus the unpaid interest and principal will be added to the amount you owe on the loan, not subtracted. Payment-option ARMs have a built-in recalculation period, usually every five years. There are a lot of details to keep track of in choosing this type of loan, so buyer beware.
The hybrid ARMs are the most popular choice of the three types offered, mostly because they are the easiest to understand and most practical for new homebuyers, but Vogel offers a warning.
“With interest rates rising, I would not advocate getting an adjustable rate loan that adjusts after short period of time like one to three years,” he said. “However, if one were buying a starter home and planning to move, it might make sense to get a loan that is fixed for 5, 7 or even 10 years and get the benefits of the lower mortgage payments during the time you own the home.”
How Adjustable Rate Mortgages Are Calculated
The method for calculating interest rates on ARMs is based on a simple mathematical formula: index rate + margin = interest rate.
The index rate typically is based on one of three indexes: the London Interbank Offered Rate (LIBOR); the one-year Treasury Bill; or the Cost of Funds Index (COFI). Some lenders have their own cost of funds index so it’s important that you ask what index is being used and where it is published so you can keep track of it.
Your lender chooses which index to base your rate on when you apply for the loan, but the LIBOR is the most popular index used.
Your lender also determines the margin you will pay, which is the number of percentage points added to index. The margin percentage varies from one lender to the next and should be a focal point of your research when applying for an ARM. That margin should be constant throughout the life of your loan.
In the spring of 2018, the LIBOR index was 2.66%. The common margin rate was around 2.75%. Using the formula above – index rate (2.66) + margin (2.75) = an interest rate of 5.41%.
Interest Rate Caps
There are many aspects of an adjustable rate mortgage that consumers should pay attention to, but one feature that demands attention is the caps on interest rates at every juncture in the loan. The name on the loan tells consumers that the rate will change every year, but if you don’t read the terms and conditions closely, you may not realize how much they will change or how often they will change.
Just as important: what are the conditions that kick in when a rate does or does not exceed the change maximum changed allowed by law?
Let’s start at the beginning. There are two interest rate caps for ARMs: periodic adjustment and lifetime.
The periodic adjustment cap limits the amount the rate can go up or down from one adjustment period to the next. In most cases, the interest changes on an annual basis, but it could change every six months or even every month, depending on what type of ARM you agree to.
A lifetime cap is a limit on the amount that interest can increase over the life of the loan. The usual number is 5-6%. So, for example, if there is a 6% lifetime cap and you have a 20-year ARM and the interest has gone up 6% in the 10th year, it can’t go any higher, regardless of what else happens.
The periodic adjustment cap can be more complex. If the cap on your loan is 2% and the index rate change goes up 3%, the lender can still only charge you an additional 2%, at least until the next adjustment period. If the rate doesn’t go up the next period, the lender can add in the 1% he missed the previous period because of the periodic adjustment cap.
Some Warning Signs for ARMs
The situation described in the paragraph above is called a carryover and it is one of the many terms and conditions of ARMs that are missed or misunderstood by consumers. Like any contract, it is wise to read and understand all the terms and conditions of an ARM before you sign.
Many people like the low, teaser rates offered by ARMs and think they will be out of the house before the adjustable rate period takes over and higher monthly payments come due.
That may be the case, but if you can’t sell your home or the value of the home declines, or for whatever reason decide to stay, you should consider in advance what the highest payment you’ll have to make will be and whether you think you can afford it.
Here are some terms you should be familiar with if you plan to go with an ARM.
- Discounted interest rates. Some lenders will offer a teaser interest rate that is even lower than their fully indexed rate, to entice customers to agree to an ARM. These are called discounted rates, but they usually expire after the first adjustment period and cause your rate to jump dramatically. Ask the lender how much your payment will increase and determine whether you can still afford the loan at the higher rate.
- Negative amortization. This is one of the dirty words in adjustable rate mortgages. It means that the amount you owe increases, even as you make payments. It happens when the amount you pay isn’t enough to cover the interest on your loan. The difference between the two is added to the balance of your loan and interest is charged on that. The result is that you may owe more a few months into the loan than you did at the beginning. That easily can happen if you choose the payment options ARM. Ask your lender if there is a chance of negative amortization in your loan. If there is, get up and walk away.
- Prepayment penalties. Another of the nasty consequences of certain ARMs that make them a financial disaster. Some ARMs, especially interest only and payment options, charge fees if you try to pay off the loan early. That means if you decided to sell your home or refinance it, you will pay a penalty on top of paying off the balance on your loan. These penalties can amount to thousands of dollars, even if you’ve only had the loan for 2-3 years. Again, ask the lender to outline any prepayment penalties and the amount it will cost you.
The bottom line for adjustable rate mortgages is to be careful what you sign up for.
When interest rates are as low as they have been the last decade, consumers typically choose a 30-year fixed mortgage for the safety and security of know the monthly payment will never change.
However, as interest rates rise, ARMs can accommodate those who want low payments early in the loan or who don’t expect to live in the home for 30 years.
Either way, be certain you understand the pros and cons of adjustable rate mortgages. Before you make a final decision, know the timing sequence for rate adjustments, the caps that apply and what penalties you will pay for not fulfilling the terms and conditions of the loan.
“Only sophisticated borrowers should get ARMs,” Vogel said. “If you are stretching to afford the mortgage, this is probably a risk you should not take.
“The great thing about a fixed rate mortgage is that you know exactly how much you have to pay for your biggest housing cost and if rates go down you can refinance and get an even lower rate.”