What Is an Adjustable Rate Mortgage (ARM)?

What Is an Adjustable Rate Mortgage (ARM)?

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It’s like learning a new language and acronyms when shopping for an Adjustable Rate Mortgage. It’s overwhelming.

How do you answer a loan officer who asks you if you prefer an ARM or a fixed-interest loan?

Continue reading to find out everything you need about ARMs — adjustable-rate mortgages.

What is an Adjustable Rate Mortgage (ARM)?

An adjustable-rate mortgage sounds exactly like it: a mortgage where the interest rates change over time. Compare it to fixed-interest mortgages where the interest rate remains the same for the entire loan term of 15-30 years.

How do ARM Interest Rates work?

Two factors are related to ARM interest rate changes: benchmark indexes, and margins.

mortgage lenders set the interest rate using a benchmark index when they issue an ARM. The Fed Funds rate and LIBOR (London Interbank Offered Rate) are two popular benchmarks. These are the baseline interest rates banks use when lending to each other.

You may not be as creditworthy as banks, so lenders must make a profit on loans. They charge a margin above the low baseline index rate.

Let’s say, for example, that you take out an ARM with a 4% margin above the LIBOR. You would be charged interest at 4.5% if the LIBOR was 0.5%

Your loan’s interest rate resets most often once a year. However, some ARMs reset less frequently.

Fixed-Rate Periods

You typically get an ARM for your first loan. This entitles you to a set number of years and a fixed rate.

This is a sweetener for the deal. Lenders will offer a low-interest rate to borrowers for the first three to seven-year of the loan. The interest rate usually jumps up once it switches over to adjusting.

This works in the favor of the lender because you either pay the higher interest rate or you refinance your mortgage to get a lower one. Lenders make money from up-front fees when you get a loan. They also earn a large amount of interest on the loan’s beginning, which means that more of your monthly payments go toward interest than to paying down your principal.

Fixed-interest loans are preferred by lenders to ARMs because they allow them to earn market interest rates for the entire loan term. They will charge more if interest rates rise. They don’t have to keep the same low-interest rate that you received when you took out your first loan.

Two numbers are often included in ARM proposals. For example, “5/1 ARM” indicates the length of the fixed-rate period. The second number indicates how often the interest rates adjust after that. The 5/1 ARM has five years of fixed interest and then the rate adjusts every year.

Caps on Interest Rates

An interest rate cap is a feature that most adjustable-rate mortgages have. This limits the rate at which it can rise. These payment caps prevent you from paying a high-interest rate, which can cause your mortgage payments to increase.

Lenders often place a 5% cap ARM interest rate. This means that your rate cannot go higher than five percentage points above the introductory rate. Your interest rate would be limited to 9% if you pay a fixed rate introductory rate of 4%. The lender can’t charge more even if your benchmark index and loan margin were higher.

ARM vs. Fixed-Rate Mortgage

Fixed-rate loans have a fixed interest rate that is applicable for the life of the loan. It doesn’t matter what benchmark interest rates change in the next decades. You will continue to pay the same interest rate up until your loan is fully paid off.

To protect themselves from future interest rate changes, lenders prefer to issue ARMs. ARMs are often offered with a lower initial rate than fixed-rate mortgages.

A fixed-interest loan is more sensible in these times of low-interest rates. However, there are some exceptions. For example, if you intend to move before the fixed-rate period ends or if your credit is poor and you cannot qualify for a high fixed rate. If your credit is poor, you can take the ARM that’s cheaper for now and then spend five years improving credit to refinance for a lower fixed interest rate.

Types of ARMs

All adjustable-rate loans are not created equal. Before you commit to an adjustable-rate loan, make sure that you fully understand the differences between ARMs.

Hybrid ARM

Hybrid ARMs include the fixed-interest period that is introductory for the period outlined above. Hybrid ARMs make up the majority of ARMs. To sweeten the deal, lenders will offer ARMs at a low fixed rate because they prefer them.

Interest-Only ARM

Interest-only loans sound exactly like they are. Instead of paying interest each month, you only have to pay interest. You don’t have to pay any money toward your principal balance. The principal balance is then paid back at the end.

I borrowed $25,000 interest-only from a couple who were real estate investors at 10% interest. I am paid $2,500 annually in interest (10% on the loan balance). They’ll pay me back the $25,000 they lent me when they are ready.

Interest-only ARMs function in the same way, but the interest rate is adjusted. You might pay 5% this year but your interest payments to the lender will increase if benchmark rates rise.

Homeowners are unlikely to receive interest-only loans. Home loans are typically amortized. This means that you repay a percentage of the principal balance each month. This allows you to gradually reduce the principal balance.

Payment-Option ARM

Some ARMs offer some flexibility when it comes to how much you pay each month. These options include:

  • Full Principal and interest: A regular monthly payment is made that includes both interests as well as money towards your principal balance.
  • Interest-Only You pay only interest, just like a traditional interest-only.
  • Minimum – You don’t pay enough to cover the interest. This is the minimum payment for a credit card, which avoids late fees, but only allows you to pay more interest.

You can see that payment-option ARMs are a tool for digging yourself into debt. While flexibility is a welcome feature during the lean months, it can be easy to get buried under a mountain of interest.

If you pay less than the minimum amount, you will end up paying interest. It’s like compounding in reverse. Your interest spirals upwards over time.

Negative Amortization ARM

Although it is rare, this type of mortgage works on the same principle that minimum payments. The principal balance is not paid and you don’t pay enough interest to pay it off.

Lenders offered ARMs with an introductory period of negative amortization. The initial monthly payments were kept low by this arrangement. The payments would then rise so that the borrower eventually pays back all the principal and interest.

These loans were introduced by lenders in the 1980s when interest rates were high. They also expected that rates would fall in the future. Payment-option ARMs were largely replaced by negative amortization ARMs in the 1990s.

Should You Refinance an ARM?

Most borrowers will plan to sell their house or refinance their mortgage in order to reduce their interest rates.

Refinance your mortgage has many downsides.

You can expect to pay thousands in title fees and lender fees as well as other closing costs.

Your amortization schedule is also reset, in addition to the refinancing fees. The bulk of your monthly payments go toward interest, instead of principal. This means that the proportion of each monthly payment going towards interest decreases gradually over the term of the loan. You will pay most of your principal balance within the last few years.

Lenders don’t want you to reach that point. Lenders want to continue refinancing you for as long as possible, in order to continue earning the new closing costs. They want you to return to Square One on your amortization schedule.

It’s a never-ending cycle of debt where they keep tempting you are with cash from the equity in your home — and continue to extend your debt horizon forever.

If you intend to live in your home for an indefinite period of time, a fixed-interest loan is the best option. An ARM is a loan that you can take out if you intend to move within the fixed-interest period. You must sell before that date to avoid a spike in your monthly payments.

Pros of Adjustable-Rate Mortgages

Although many borrowers may be suspicious of ARM loans, they can make sense for some borrowers.

When shopping for mortgages, keep these ARM benefits in mind.

  1. Low Fixed Interest Period. To attract borrowers, lenders use low fixed interest rates for the initial fixed period. They charge a lower interest rate than a fixed-interest mortgage during this time. ARMs are a great way to save money if you intend to sell your house or refinance it before the initial period ends.
  2. Interest Rate Limit. Lenders can limit how high-interest rates and monthly mortgage payments can rise even if they rise.
  3. Lower payments are possible. Although it is unlikely, it is theoretically possible for your monthly payment and interest rate to drop if interest rates fall between now and the end of your fixed-interest period.
  4. Subprime Borrowers Allowed. ARMs were considered subprime mortgage products during the 2000 housing boom. ARMs could be available to borrowers with poor credit, providing a monthly payment that is affordable — up until the fixed interest period ends. It is up for debate if people with poor credit should rent or buy a home, but ARMs provide a gateway mortgage to help them purchase their first home.

Learn more about: How to Pay Off Your Mortgage Early – 7 Tips for Home Loan Repayment

Cons of Adjustable-Rate Mortgages

There are many drawbacks to adjustable loans. Before you buy a house with an adjustable loan, make sure to fully understand them.

  1. More Likely. The margin is priced by lenders so that the borrower will pay a higher interest rate than the low fixed rate. Lenders price the margin so that you will pay a higher interest rate even if benchmark rates drop slightly between now and when your rate adjusts.
  2. Prepayment Penalties Possible. Some ARMs have a prepayment fee. Lenders charge this fee if the loan is not paid off within the first two to five years. You could be penalized if you take out an ARM temporarily to get the lower initial interest rate. Before you agree to a loan, double-check the prepayment penalty.
  3. The Risk of Keeping an ARM. It doesn’t matter if you intend to sell the house or refinance it before the interest rate adjusts. It is possible to decide to remain in your home, which could leave you with two options: refinancing the loan or keeping your expensive ARM. Refinancing can be more difficult or more costly if you have a lower credit score.
  4. Complexity. Nobody wants to have more complicated finances, especially when they are paying such high monthly bills. Even the most financially-savvy borrowers can be confused by adjustable-rate mortgages’ complicated rules and high costs. ARMs are a bait-and switch. Lenders lure you in by offering a low initial rate of interest, knowing that they will either charge higher interest after the intro period ends or lucrative refinance fees.

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