What is an ARM?
An Adjustable Rate Mortgage (ARM), unlike a fixed-rate mortgage, has an interest rate that changes. Mortgage lenders offer these plans to lessen their losses when the interest rate goes up, because they can pass increases on to borrowers. Since initial rates for ARMs are set lower than rates for fixed-rate mortgages, an ARM can be easier to afford at the start than a fixed-rate loan. However, borrowers choosing an ARM must realize that their monthly payments can, and probably will, increase over time.
Video: What is an Adjustable Rate Mortgage?
Questions to consider
If you are thinking about buying a home with an ARM, consider these questions:
- Will my income rise enough to keep pace with monthly payment increases if interest rates go up?
- Do I plan to stay in this home a long time or leave it soon? If you plan to sell soon, a few increases in interest rates might not be a problem.
- Will I want to get out of the ARM and move to a fixed-rate mortgage? This can be done, but sometimes at a cost high enough to negate the money you saved by going with an ARM in the first place.
Video: Suze Orman - Should You Refinance Your ARM?
Variables to investigate
You have five major variables to investigate when talking with a lender about an ARM:
- The initial interest rate. The rate you will pay during the first year or so of a loan. The quote will no doubt sound enticingly low.
- The adjustment period. The length of time that the interest rate or loan period on an ARM remains unchanged. After that, the monthly payment is recalculated.
- The index. Lenders use it to set ARM rates, and it is often determined by the interest rates of federal Treasury securities. As index rates rise, so do your interest rate and monthly payment.
- The margin. Is the lender’s markup over the index, his profit.
- The interest rate cap. It limits how much the interest rate or monthly payment can be changed each adjustment period or over the life of the loan. Note that an interest rate increase not passed on to you one year because of a rate cap can be carried over to the next.
Common types of ARMS
There are several different types of ARMs.
- A hybrid ARM is a mixture of a fixed-rate period and an adjustable-rate period. The interest rate is fixed at the start of the loan, then can be adjusted.
- A payment-option ARM allows you to choose to pay either principal and interest or something less than the interest due each month. If you choose the latter option, unpaid interest will be added to the principal, increasing future monthly payments and the total interest you will pay.
- An interest-only ARM lets you pay only the interest for up to 10 years, minimizing initial monthly payments. Payments increase when you must start paying off the principal plus the interest.
Payment shock
Payment shock describes how some borrowers react when their ARM payments rise sharply. Let’s assume you have a $200,000 loan. The monthly payment at a rate of 4% the first year is roughly $955.00. At 6% the second year, your monthly payment is about $1,193.00. At 7% the second year, the payment rises to roughly $1,320.00. You must be willing and able to accept such potential increases before you sign on the dotted line.