Adjustable Rate Mortgages (arm)
An ARM loan or Adjustable Rate Mortgage, is a mortgage with a rate that can adjust. While the term has been vilified as one of the causes of the dreaded, “mortgage meltdown”, not all ARM’s carry mortgage rates that are unreasonable. Just like most anything, all it takes is a little effort to understand the different ARM programs and to see if they would be beneficial to you./wp-admin/post.php?post=669&action=edit#
To understand an ARM correctly, we need a few definitions along with our example:
John, in Chesterfield Missouri, has a mortgage application that has a start rate of 2.50%, 5/1 ARM with 5/2/5 “Caps”, and 2.75% “Margin” with the 1 Year US Treasury as the “Index”.
An Index is a guide used to measure interest rates. Examples of interest rate changes are, 1 year LIBOR(London Interbank Offered Rate, 1 year treasury, and Prime). This is available on any financial website. Your interest rate is computed based on the index, the month before your adjustment period ends.
An easy way of thinking of Margin is as the lender’s markup on funds. It’s added to the index. If you don’t know your index, its normally available on your note, or ask you loan officer if you are yet to close. This is where you need to pay close attention. Abusive lending practices were introduced into margins. A normal margin is about 2.75%, however during the time where the causes of the mortgage meltdown happened, some margins were as high as 8%.
The adjustment period is the disclosure of periods the rate is fixed before it adjusts. In our example, John from Chesterfield Missouri mortgage has a 5/1 ARM means the interest rate is 2.5% for the first 5 years, adjusting on the 61st month, then every 1 year thereafter.
Interest rate Caps
Cap on a mortgage discloses the maximum percentage an ARM can adjust per period and over the life of the loan, or “Capped”. For example, the 5/2/5 caps means John in Chesterfield’s ARM can’t adjust to more than 7.5% on the first adjustment, no more that 2% per year thereafter, and no more than 7.5% over the life of the loan. Again, this is also a place to pay close attention. ARM caps are there to protect the consumer against unreasonable interest rate jumps. A normal ARM cap for the 1st adjustment is 2-5%. During the pre-mortgage meltdown days, we saw no cap and a life cap of up to 18%!
So How is my ARM rate computed?
Index + Margin = Interest rate, limited by the interest rate cap.
So, using our example above. John from St. Louis (Chesterfield) has had his ARM mortgage for 5 years now and the US Treasury is at 1%. So Index of 1 + margin of 2.75=3.75% will be John’s new interest rate for the next 12 months.
When Should I choose an ARM?
Provided this isn’t your first rodeo owning and financing a home, you could consider and ARM if:
- You plan on being in your home for the a time period less that the fixed period of the ARM. Say, if you are planning on moving in 4 years, a 5/1 ARM may work well for you.
- You have additional income coming in soon. Say, you are first in line for the next promotion and Junior’s college fund has not yet been fully funded.
So, to conclude, ARM’s aren’t for everybody, and they can have some tricky parts. However, provided you’ve done your research, they can be of benefit in the right circumstances.