In recent years, fixed-rate mortgages (FRMs) have dominated mortgage lending, and for good reason. Home buyers and refinancing homeowners have been eager to lock down record-setting low interest rates for as long as they can. However, just because FRMs are the most popular doesn't make them the most appropriate home loans for all borrowers -- or even most borrowers. For many, ARM rates create substantial savings, and adjustable rate mortgages (ARMs) represent the best deal in home financing.
The ARM Discount
When mortgage lenders fund fixed home loans, they risk losing money if interest rates rise -- if they are getting four percent for 30 years, but market rates have risen to eight percent, those loans could be costing lenders money every month. The lower current 30 year fixed rates are, the more likely it is that they will increase in the next few years.
In order to shift some of this interest rate risk onto borrowers, lenders offer adjustable rate mortgages with rates that can increase when market rates rise and decrease when they fall. Of course, few borrowers would be interested in taking on extra risk unless they got something in return. That's where the discount comes in -- it's called a "teaser" rate or start rate and it's considerably lower than 30 year mortgage rates and 20 year fixed rates. In July of 2014, for example, the 30 year fixed rate (pulled from LendingTree's LoanExplorer tool) was 3.958 percent (APR) and the 3/1 ARM had an APR of just 2.562 percent. That start or teaser rate is fixed for three years and then it adjusts (resets) at regular intervals until it's paid off or refinanced. With a $300,000 mortgage, the 3/1 payment is $225 a month less than the 30 year fixed payment.
ARM teasers rates can be fixed for periods as short as one month to periods as long as ten years.
How ARM Rates Are Set
ARM rates are calculated from the same components: an index and a margin. The index is a published number that reflects economic conditions and moves up and down over time. According to the Federal Reserve, the most common indexes are the 1-year constant-maturity Treasury (CMT) the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
The margin is a percentage that the lender adds to the index and is usually between two and five percent. The sum of the index and the margin are added to determine the interest rate, called the fully indexed rate. Thus an ARM based on the 6-month LIBOR index (which was .33 percent in July 2014) with a 3.0 percent margin could be expected to reset to 3.33 percent. However, this rate may be affected by other parameters -- rate caps and floors.
Rate caps and floors limit how high or low a mortgage rate can go. The periodic cap restricts the size of the increase when it's time for the interest rate to reset. The limit for the first adjustment may be higher than the limit for subsequent adjustments -- for example, the first periodic cap on a 3/1 ARM might be three percent, and the cap for adjustments in years four through 30 might be two percent.
In addition, ARMs come with lifetime caps, which limit how high the interest rate can go over the life of the loan. These are usually set five or six percent higher than the start rate.
Finally, there are floors, which set the lowest possible rate of the loan. In the example above, the loan's fully-indexed rate (index plus margin) is 3.33 percent. But if the lender has set a floor of 3.5 percent, that's as low as the rate will go.
When Do ARMs Make Sense?
According to the National Association of Realtors (NAR), the average homeowner keeps a home about six years -- older residents stay longer and younger ones tend to move sooner. For those who expect to sell and move in a few years, an ARM can create substantial savings. The chart below illustrates approximate savings over different timelines based on APRs from available programs on July 21, 2014.