Adjustable-Rate Mortgages: 3 Essential Ingredients

Have you automatically chosen fixed mortgage and refinance rates because you considered adjustable-rate mortgages, also called ARMs, to be complicated? Understanding what makes ARMs work can help you compare adjustable to fixed rates along with potential benefits according to your mortgage needs, financial situation and future plans. Knowing factors used by lenders in establishing and changing adjustable mortgage rates can also increase your confidence when comparing mortgage options as they relate to your particular needs.

Financial Indexes, Margins Used by Lenders for Setting ARM Rates

Mortgage lenders use various financial indexes as benchmarks for their adjustable mortgage rates, which underscores the importance of shopping adjustable mortgage rates. According to the Consumer Financial Protection Bureau, the one-year London Inter-Bank Offer Rate, or LIBOR, is often used for establishing the base rate for ARMs. LIBOR and other index rates are published in the financial sections of major newspapers. The applicable index rate is the first component of determining an ARM rate.

The next is called a margin, which is an additional percentage added by mortgage lenders to establish their ARM rates. As with index rates, margins used by lenders vary. Here's a fictional example: Lender ABC uses a current index rate of 2.25 percent and adds a margin rate of 1.75 percent. The adjustable mortgage rate in this case would be 4.00 percent. The following year, the index rate falls to 2.00 percent, which means that the adjustable mortgage rate would fall to 3.75 percent until the next adjustment period. This is a simplified example, as interest rate caps are also used to determine how or if adjustable rates can change.

Rate caps are designed to manage the rise and fall of adjustable mortgage rates as determined by the movement of financial indexes. In most cases, caps protect mortgage borrowers from rapidly rising mortgage rates by establishing a cap, or maximum limit on how much ARM rates can increase at each adjustment period. Rate caps can also keep the bottom from falling out of adjustable mortgage rates if financial markets tank. Here's another fictional example. Joe and Susie have an ARM with an index rate of 2.00 plus a margin of 1.25 for an ARM rate of 3.25 percent. Joe reads in the paper that their index rate has crashed by one percent. He thinks that this means that their mortgage rate will adjust to 2.25 percent, but not so fast. Joe and Susie's loan has an adjustment cap of .30 percent per adjustment. This means that their mortgage rate can only decrease to 2.95 percent.

Lifetime caps limit how much interest rates can change over the lifetime of adjustable-rate mortgages. Most adjustable-rate mortgages have an initial fixed interest rate for a period of years. As an example, we'll say that Joe and Susie's adjustable-rate mortgage has an initial rate of 2.75 percent; if the lifetime cap on this mortgage is 2.50 percent, their mortgage rate could not exceed 5.25 percent over the life of their mortgage.

Adjustable-Rate Mortgages: A Word About Numbers

Mortgage lenders typically advertise ARMs in a format of two numbers separated by a slash, such as 3/1 or 5/1.The first number describes the initial fixed interest rate for an ARM. 3/1 indicates an initial rate for 3 years with one yearly adjustment thereafter. When shopping for adjustable rate mortgages, always ensure that you know:

  • The index and margin rates used
  • Periodic and lifetime rate caps
  • The initial interest rate and how long it lasts
  • How often the mortgage rate can adjust

While all of this may seem complicated, an ARM may be your best choice in certain situations. If you plan to move up to a larger home before the initial interest rate expires, or you know that you'll likely move for other reasons, ARMs with low initial fixed rates can make sense for first-time or moderate income buyers who need to keep their monthly payments as low as possible.

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