Adjustable Rate Mortgages (ARMs)

Adjustable rate mortgages (ARMs) are one of the most common financing solutions for homeowners and investors in Colorado.  As interest rates rise, we find that many of our clients prefer these depending on their circumstances.

ARMs have been around for decades and have been used as a way to pay less per month due to interest rates being relatively lower than fixed for a period of time. However, there is no way to know if you’ll be paying more or less in the future on an ARM once rates rise again after they drop back down again.

Let’s breakdown what an Adjustable Rate Mortgage is, when it makes sense and important considerations!

Topics:

• What is an Adjustable Rate Mortgage?

• When does an Adjustable Rate Mortgage make sense?

• Adjustable Rate Mortgages vs. Fixed Rate Mortgages

• What to Consider with an Adjustable Rate Mortgage

• Adjustable Rate Mortgage FAQs

What is an Adjustable Rate Mortgage?

Basically, an ARM is a home loan with an interest rate that adjusts over time based on market conditions.

• Initial rate stays the same for a fixed period of time

  1. Interest rate is changed after a fixed period of time in accordance with the value of a specified economic indicator, also known as an index.

While there are many indexes used to govern ARMs, the most prevalent types are:

• Treasury Constant Maturities (most common index; used on one-year ARMs and hybrid ARMs)

• Treasury Bills (mostly used for three month and six month ARMs)

• 11th District Cost- of-Funds (used mainly on one month and six month ARMs)

To protect you from large rate increases, most ARMs feature some form of limitations on how much your rate can move from fixed period to fixed period. These limitations are called caps. Although many kinds of cap structures are possible, the most common kinds of caps limit your change at any one time to two percentage points, and a total of six percentage points over the life of the loan. In many cases, these caps also restrict how low your rate can go.

Traditional ARMs have interest rates and monthly payments that adjust at fixed, regular intervals.

Hybrid ARMs feature a fixed interest rate for a period of years — commonly 3, 5, 7 or 10 years — before they turn into a traditional one-year ARM for the remainder of a 30-year term.

Numerical form is also used to represent different types of ARMs. This structure involves two numbers: the first number is how long your fixed-rate period will last and the second number is how often the rate will change every year.

The most common types of ARMS are 5/1, 7/1, and 10/1.

• A 5/1 ARM has a fixed rate of interest for the first 5 years of the loan. After that, the interest rate will adjust once annually over the remaining 25 years.

• A 7/1 ARM has a fixed rate of interest for the first 7 years of the loan. After that, the interest rate will adjust once annually over the remaining 23 years.

• A 10/1 ARM has a fixed rate of interest for the first 10 years of the loan. After that, the interest rate will adjust once annually over the remaining 20 years.

When does an Adjustable Rate Mortgage make sense?

Adjustable rate mortgages (ARM) can be a great choice for some homebuyers. However, they’re not right for everyone.  Rather than thinking of a home loan as “good” or “bad”, think of it as a tool to buy a home.  Depending on your goals, your financial position at the time of getting the loan, etc. will determine if adjustable rate mortgages are right for you to consider.

Here are five reasons why you should use an ARM and five reasons why you shouldn’t.

Benefits of an ARM

1.  You’re planning to sell your house soon (before rates go up)

   1.  You have stable employment and the ability to refinance before rates increase

   2.  You have a large down payment (20 percent or more — only applies to new home purchases)

   3.  You’re willing to accept the risk of rising interest rates

   4.  You want lower monthly mortgage payments for a period of time compared to fixed rates

Negatives of an ARM

• The interest rate is not fixed for the entire loan term.

  1. You may experience a change in your monthly payment that is higher than you expected and you may not be able to afford in the future due to unplanned events.

  2. You may have to pay an ARM prepayment penalty if you sell or refinance before the end of your first year

  3. If you sell during the first five years, you could lose some of your equity

Adjustable Rate Mortgages vs Fixed Rate Mortgages

The difference between fixed rate mortgages and adjustable rate mortgages is simple: the interest rate for an adjustable rate mortgage (ARM) can change over time. A fixed rate mortgage has a set interest rate for the life of the loan.

The biggest appeal of ARMs is the possibility of a lower initial interest rate than with a fixed-rate loan. But there are also risks, since your monthly payments could increase substantially if rates rise after you buy your home.

Highlights

• Fixed-rate loans are most commonly offered as 15- or 30-year terms, but ARMs are typically 30-year terms.

  1. Your starting rate may be lower for an ARM than a fixed-rate mortgage.

  2. The monthly mortgage payment may be more affordable in the first few years of an ARM.

  3. The minimum down payment for an ARM is 5%, while the minimum down payment for a fixed-rate mortgage can be as low as 3%, depending on the loan type

What to Consider with an Adjustable Rate Mortgage

• What’s the current interest rate environment? It can make more sense to get an ARM when interest rates are on the rise, as long as you plan on moving before your rate adjusts.

  1. How long are you planning on living in your Colorado home? An adjustable rate mortgage is an excellent option for those buying a starter home who plan on moving into a bigger house within the next 5 years.Typically, committing to a 30-year fixed-rate mortgage won’t grant you the same flexibility as an adjustable rate mortgage. If interest rates continue to rise as predicted through the new year, then an ARM could make more financial sense than a fixed-rate mortgage for your home loan.

  2. Do you expect any big life events in the next 5 – 10 years (marriage, children, new job)?

  3. Do you need time to comfortably afford a bigger monthly payment?

  4. Is your income unstable or going to be unpredictable in the next few years?

  5. What adjustable rate mortgage options does your lender offer? Remember, different types of ARMs work better in different circumstances. If you plan on living in your Colorado home for less than 10 years, a 5/1 or 7/1 ARM may be a good option for you. But if you plan on living in the home long-term or need extra time to create a firm financial footing, a 10/1 may be a better choice.

FAQs: Adjustable Rate Mortgages

How often does an adjustable rate mortgage change?

ARM mortgage rates will adjust based on a few factors that are determined when the loan is established. The most common are the adjustment period (how frequently the lender can adjust the interest rate on the loan), the periodic cap (the time period between each time the loan will adjust), and the lifetime cap (how much the loan can increase over the life of the loans).

What is a margin?

A margin is the number of percentage points the lender adds to the index rate to calculate the interest rate of an ARM at each adjustment. The margin of an ARM is set in your loan agreement and won’t change after closing.

What is a floor?

A floor is the minimum rate for which the interest rate can adjust down.

If my credit score is low, how can I raise it?

Paying your bills on time, reducing your credit balances, and trying to not apply for credit too often are all ways that you can raise your FICO score.

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