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Adjustable Rate Mortgages – A Guide to ARM Loans

March 13, 2009

by Brandon Cornett

Many home buyers choose the adjustable rate mortgage (ARM) in order to save money during the first few years of homeownership. But later, these same homeowners run into trouble when the adjustable rate mortgage adjusts (hence the name) to higher interest rates.

In many cases, such adjustments can greatly increase the size of the overall mortgage payment, which catches a lot of homeowners off guard. In this guide, we will examine the adjustable rate mortgage in more detail. After reading this guide, you will better understand the ARM loan and will be able to make wise decisions about such loans.

What Is an ARM?
As the name implies, an adjustable-rate mortgage differs from a fixed rate mortgage in the way it adjusts to a new interest rate at some future point in time. Fixed rate mortgage loans carry the same interest rate through the entire life of the loan. So the interest rate you would pay in Year 1 would be the same rate as years 5, 10, 15 … all the way through the end of the loan’s term. On the other hand, with an adjustable rate mortgage, the interest rate will change periodically. This can cause payments to go up or down, depending on the prevailing rate at the time of adjustment (and other factors).

In other words, an adjustable rate mortgage is a loan with an interest rate that changes at some point in the future. Most of the time, ARM loans start off with a lower monthly payment than a fixed rate mortgage. But keep the following points in mind:

– Unlike a fixed rate mortgage, the payments on an adjustable rate mortgage can change. This can increase the size of your mortgage, sometimes significantly.

– You cannot predict what the interest rates will do three or five years from now, when your ARM loan adjusts.

– It’s possible that you could eventually owe more money than you borrowed.
If you want to pay off your ARM early to avoid payment increases, many lenders will charge a penalty fee for it.

Shopping for an Adjustable Rate Mortgage
When shopping for a mortgage, it’s important to compare the rates and terms offered by different lenders. It’s like anything else in life — only by shopping around can you find the best deal. These days, comparing one adjustable rate mortgage to another can be confusing. That’s because you have to understand the concepts of index, margin, caps, payment options, etc. It is beyond the scope of this article to show comparison examples, data charts, etc. But you can get plenty of those from the Federal Reserve’s tutorial on ARM loans, available through the link below:

http://www.federalreserve.gov/pubs/arms/arms_english.htm

Primary Advantage of an ARM Loan
The biggest advantage of an adjustable rate mortgage is the lower initial interest rate. Most lenders charge lower initial rates for an ARM loan than they charge for fixed rate mortgages. And since the interest rate is a key ingredient of the mortgage payment, this would in turn lower the mortgage amount you have to pay each month. For many first-time home buyers, this can be a big selling point for the adjustable rate mortgage. But there is also a key disadvantage to these loans.

Primary Disadvantage of an ARM Loan
As we have discussed, the characteristic that makes an adjustable rate mortgage unique is that the interest rate adjusts periodically. When and how often the loan adjusts is something you will know in advance, because the lender is required by law to tell you those things. But the amount it adjusts will remain an unknown variable, because nobody can predict what interest rates will do in the future. This is the primary disadvantage of an adjustable rate mortgage, the uncertainty of interest rate changes / increases.

Key Ingredients of the Adjustable Rate Mortgage
To get an even better understanding of how the ARM loan works, you should understand the key ingredients of such a loan.

* Initial Rate – We have already discussed how an adjustable rate mortgage loan starts off with a relatively low interest rate in the beginning. This is known as the initial rate, and it will stay in place for a limited period of time — usually 1 to 5 years. But here’s the thing to remember. On most adjustable rate mortgages, the initial interest rate (and by extension the initial payment amount) can vary greatly from the rates and payments you would face later in the loan’s term.

* Adjustment Period – This is just what it sounds like, the period during which your adjustable rate mortgage adjusts to a new interest rate (and payment amount). Usually, the interest rate on an ARM loan will change every month, quarter, year, 3 years, or 5 years, with the latter options being the most common. A loan with an adjustment period of 1 year is called a 1-year ARM, which means the interest rate and payment can change once per year (after the initial period).

* Loan Descriptions – The law requires that mortgage lenders must give you written information on each type of ARM loan you are interested in. The information they provide must explain the term / conditions for each adjustable rate mortgage, as well as details about the index and margin (which determine the interest rate), how your rate will be determined, how often the rate will change, caps (or limits) on rate changes, plus an example of how high your monthly mortgage payment might go based on adjustments.

* Interest Rate Caps – Interest-rate caps are an important concept in the world of adjustable rate mortgage loans. A cap is just what it sounds like … a limit on the amount your interest rate can increase. Interest rate caps come in two versions: 1. Periodic adjustment caps limit how much the interest rate can go up or down from one adjustment to the next (after the first adjustment). 2. Lifetime caps limit the interest-rate increase over the life of the loan. Lifetime caps are required by law, so you’ll find them on nearly all adjustable rate mortgage loans.

* Payment Caps – Many ARM loans also cap (or limit) the amount your monthly payment can increase at the time of each adjustment. So if your adjustable rate mortgage loan had a payment cap of 8%, your monthly payment would not increase more than 8% over your previous payment amount. Be Careful Choosing an ARM Loan

Avoiding Payment Shock
In your financial planning, the biggest thing you want to avoid is payment shock. Payment shock is what happens when your mortgage payment rises steeply during a rate adjustment. For example, let’s say you took out an adjustable rate mortgage for a $200,000 loan. During the first year of an ARM, you’ll usually enjoy a very low interest rate. That’s the primary benefit. So let’s say you start out with a 4% interest rate that later goes up to a 7% interest rate (after the second year). During the first two years, the mortgage payments would be somewhere in the neighborhood of $950 per month. But after the adjustment at year two, those payments would go up to more than $1,300. That’s a big difference.

Percentage points may not seem like much by themselves. But when you plug them into a mortgage calculator, you can see how significant they really are. So if you are considering an adjustable rate mortgage, just be wise about it and think long-term. If you plan to stay in the home and hold the loan for many years, make sure you have a plan for when the rate adjusts. Or make sure you can handle a significantly larger mortgage payment.

Conclusion
Here’s what we want you to take away from this lesson. Adjustable rate mortgages offer benefits up front (during the initial period) in the form of lower interest rates. But they are full of uncertainty later on, and this can lead to unpleasant financial surprises. If you understand this concept, and you plan to sell the home a few years down the road, an ARM loan might be a good option for you.

But if you’re not comfortable with the uncertainty of rate and payment adjustments, or if you plan to stay in the home (and hold the mortgage) for many years, an ARM loan might be a bad idea.

About the Author: Brandon Cornett publishes the Home Buying Institute, a website full of advice on mortgages loans, house hunting, credit scores and more. Learn more or contact the author by visiting www.homebuyinginstitute.com

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