Adjustable Rate Mortgages
An Adjustable Rate Mortgage (ARM) can make a house more affordable because a homeowner can finance the purchase at an interest rate lower than a fixed-rate loan.
That’s because ARM interest rates are calculated using a specific economic index such as U.S. Treasury securities, LIBOR (London Inter-Bank Offered Rate), COFI (Cost of Funds Index) or CODI (Cost of Deposit Index) instead of the array of market conditions that help determine fixed-rate mortgages.
The indexes, however, do vary in their susceptibility to market conditions. Treasury securities and LIBOR, for example, are more volatile than COFI, which can affect interest rates tied to these indexes.
Fixed-rate mortgages offer a permanent interest rate over the loan’s term, which usually is 15 or 30 years. ARMs offer rates that become adjustable after an initial period of one, three, five, seven or ten years. After the initial period, rates often can be adjusted annually or every six months. An ARM defined as 5/1, for example, will have its first adjustment after five years and annual adjustments after that.
In shopping for an ARM, buyers should consider the interest rate offered and the index used as the basis for adjustment. Fixed rate borrowers need only consider the interest rate.
Most ARMs have caps on how much the rate can rise or fall at each adjustment and ceilings that determine the maximum rate during the life of the loan. A margin, which is the lender’s cost, is added to the index value to determine the rate. The margin stays the same for the life of the loan.
If the initial interest rate for a three-year (3/1) ARM is 3 percent, for example, and the limit on increases is 2 percent, that means the rate could rise to 5 percent at the first adjustment period. If the maximum rate is 9 percent, that means it would take at least three adjustment periods or six years to reach the maximum under the worse scenario.
Savings on mortgage interest can be considerable using an ARM instead of a fixed rate mortgage if there is a significant difference between the two interest rates. ARMs can be a good investment for buyers who plan on keeping a house for only a few years or for those who need time to build a better credit score to qualify for a fixed rate loan.
Many ARMs are called hybrid loans because they include the initial fixed-rate period followed by adjustments. A convertible ARM or a two-step mortgage can later be turned into a fixed rate mortgage. A 5/25 two-step mortgage, for example, is a 30-year mortgage with one rate adjustment after five years.
Some ARMs offer an interest-only option in which no payments are made on the principal.
During the housing boom, when home prices were beyond the reach of many buyers in hot markets like California, the Option ARM offered a way to make homes affordable. Under an Option ARM, the borrower chooses how much to pay each month from four options including a minimum payment, interest-only payment and 15-year or 30-year amortized payments.
The Option ARM is an example of a negatively amortizing loan in which any unpaid interest is added to the loan balance. Graduated payment mortgages also start with a negatively amortized payment with regular rate increases.
The recession and declining home prices in some markets brought an end to the popularity of negatively amortizing loans because home prices weren’t rising fast enough to cover the additional principal.
In a healthy economy, where home values and wages are rising, ARMs can help buyers get into the market or afford a more expensive home by allowing them to qualify for a larger loan. These kinds of mortgages also can make homes affordable when fixed mortgage rates are high.
Jay and Sara, for example, are a young professional couple in their mid-20s. Their wages are likely to rise over the next few years. Financing a home purchase with an ARM can help them afford a home today.
In a few years, they probably can afford a rise in the ARM’s interest rate since their wages likely will be higher. If the home goes up in value, they can sell it and pocket the difference in equity.
An ARM can be riskier, however, in a bad economy. If wage increases are stagnant or the unemployment rate is high, homeowners could have difficulty affording interest rates that adjust higher. Selling the house without a loss also could be harder if the market is slower or if home values decline.